The outlook for the UK water sector remains stable on expectations that it will maintain its solid performance until the end of the current five-year regulatory period in March 2015, says Moody's Investors Service in its Industry Outlook report on the sector published today.

Moody's anticipates that returns during this period will be broadly in line with regulatory assumptions. The UK water sector has been on stable outlook since Moody's first industry report in 2004.

However, Moody's report says that while the outlook for the sector remains stable individual companies are facing challenges.

"We expect the new five-year regulatory period, which starts on 1 April 2015, to support the stable outlook as it will follow established regulatory principles despite amendments to the framework and methodology for setting price limits," says Stefanie Voelz, a Moody's AVP - Analyst and author of the report. "Whilst the outlook is stable for the sector as a whole, individual companies may face challenges related to their operational performance or financial structure if these deviate from sector norms."

In the report, Moody's notes that low interest rates will drive a reduction in wholesale businesses' allowed returns in the next price review. For some companies, balance sheet strengthening may be necessary to maintain credit quality. Changes to cost recovery mechanisms in the 2014 price review (PR14) may provide some scope to offset the impact of lower returns on cash flows, although the rating agency's credit ratios will look through any adjustments to the speed of cost recovery.

Moody's notes that highly-leveraged companies are most at risk from a challenging PR14. Companies with high gearing, such as Southern Water (Baa2 negative), which has a Net Debt/Regulatory Capital Value (RCV) ratio of around 81%, are at risk if they cannot offset a cut in allowed returns with improved performance or adjustment to financial and dividend policies. In contrast, companies like United Utilities (A3 stable), Severn Trent (A3 stable) and Welsh Water (A3 stable) are well-placed to accommodate the new framework because of relatively low leverage (around 60%-65% of Net Debt/RCV) for their rating categories.

According to Moody's report, retail cash flows will be too small to significantly affect revenues. Two separate retail price controls (for household and non-household customers) will determine additional cash flow potential in the new regulatory period. While retail margins may improve overall cash flows, it is unlikely that the additional allowance will have a material influence.

Moody's also notes that overall performance indicators suggest no rating constraints, but that these indicators will influence the Water Services Regulation Authority's (Ofwat) assessment of business plans. Most companies are performing in line or better than regulatory expectations in key service areas. Customer service, which is receiving increasing attention through the application of the service incentive mechanisms (SIM), will form an important part of the new retail price control.

Ofwat is working on a very tight timetable to finalise PR14 and Moody's sees elevated execution risk, given the introduction of new cost assessment methods, such as total expenditure, and a different approach to companies' business planning and the way the regulator will scrutinise these plans.

Moody's concludes that medium- to long-term risk remains in the UK water sector. Ofwat continues to work on introducing competition to other parts of the value chain, particularly in the upstream business, including water abstraction, resources and treatment. However, these plans are unlikely to have any impact prior to 2019.

Subscribers to Moody's can access the full report here