Fitch Ratings has downgraded Yorkshire Water Service Finance's and Yorkshire Water Finance plc's senior secured class A debt rating to 'A-' from 'A', and subordinated class B debt rating to 'BBB' from 'BBB+'.

Fitch has also downgraded holding company Kelda Finance No. 2's (Kelda) Long-Term Issuer Default Rating (IDR) and senior secured debt to'B+' from 'BB-', and removed all ratings from Rating Watch Negative. Fitch has also withdrawn all Kelda's ratings for commercial reasons.

The ratings agency said the downgrades of the water company’s debt ratings reflects pressure on Yorkshire Water Services financial profile from Ofwat's challenging final price determinations (FD) - and the ratings are weakly positioned at the new levels.

According to Fitch, has the announcement by Ofwat of a significant cut to the allowed weighted average cost of capital (WACC) to 1.96% (real, long-term RPI of 3%) from 3.7% (2.8%) for AMP7 will put pressure on YWS's cash flow and interest-cover metrics. The utility’s second quartile ranking regulatory performance and challenging performance commitments are also likely to lead to meaningful outcome delivery incentive (ODI) penalties in AMP7.

The ratings agency also views the outcome of Yorkshire Water’s appeal against Ofwat's FD to the Competition and Markets Authority, as uncertain, based on their opposing views of long-term, saying it could be either favourable or unfavourable for the company's financial profile.

Fitch is forecasting £77 million in net ODI penalties for YWS's operational delivery in AMP7, of which £48 million will impact AMP7's cash flows, driven by challenging performance commitment targets.

Fitch said that while YWS benefitted from a few” well-structured financially rewarded ODIs” and only incurred modest penalties during AMP6, this will change in AMP7. It expects most of the AMP7 penalties to come from mains repairs, drinking water contacts, internal sewer flooding, water-quality compliance and leakage. Internal sewer flooding penalties are expected to be mostly offset by external sewer flooding rewards.

Describing the water company as a “mid-ranking performer” the ratings agency said that in the first four years of AMP6 it had demonstrated average operational performance compared with the sector's, pointing out that although it had received substantial net ODI rewards, its performance on leakage, internal sewer flooding, pollutions and customer service was below sector-average.

Of the forecast £60 million net ODI rewards (in 2012/13prices) for AMP6, it anticipates £30 million to come from supply interruptions, £25 million from internal sewer flooding and £22 million from pollution incidents, while drinking water contacts performance is expected to result in a £17 million penalty.

The agency expects only limited revenue impact from COVID-19, with the pandemic expected to marginally impact Yorkshire’s revenue as lower non-household (NHH) consumption will likely be offset by an increase in households (HH). Revenue collection is expected to suffer from the lockdown, with a potential increase in bad debts of around £10 million over FY21-FY22.

Fitch goes on to say that a rating upgrade is unlikely in the medium term. In the longer term, an upgrade could be considered if YWS maintains lower debt gearing levels - which could be achieved via a combination of a favourable outcome of the CMA appeal, significant outperformance versus Fitch's current totex and ODI assumptions and substantial balance-sheet strengthening

Factors that could, individually or collectively, lead to a further negative rating action/downgrade include an unfavourable outcome of the CMA appeal, deterioration in operational performance, and substantial and prolonged impact of coronavirus on revenue recovery.