According to Moody's Investors Service, recent Ofwat guidance indicates a significant reduction in allowed returns for UK water companies, with Anglian Water, Thames Water, Yorkshire Water and Southern Water particularly at risk.

Moody's said that the highly geared companies, including Anglian Water Services Ltd (Baa1 stable), Thames Water Utilities Ltd (Baa1 stable), Yorkshire Water Services Ltd (Baa1 stable) and Southern Water Services Ltd (Baa2 negative), are most exposed to a reduction in returns because of their low interest cover ratios.

Subject to the final outcome of the review, Moody's now expects negative credit pressure for these companies, unless management and shareholders are able to implement balance-sheet strengthening measures.

On 27 January 2014, the Water Services Regulation Authority (Ofwat), the economic regulator for water and sewerage companies in England and Wales published guidance for returns the companies will be allowed to earn on their assets over the five year regulatory period starting in April 2015. According to the regulator, this is likely to fall to 3.85%, 1.25 percentage points below the 5.1% return set in 2009 for the current regulatory period.

"Ofwat has followed established principles in arriving at its guidance for the allowed return and the reduction essentially reflects the fall in interest rates since price limits were last set in 2009, and an ongoing low market return environment" said Stefanie Voelz, Moody's Vice President and author of the report. "The guidance is consistent with other recent regulatory determinations in the UK and reflects Ofwat's duty to protect customers' interests," added Ms.Voelz.

Moody's views Ofwat's stance on the cost of capital as particularly credit negative for the holding companies of highly leveraged companies, such as Anglian Water (Osprey) Financing Plc (Ba3 negative) and Thames Water (Kemble) Finance Plc (B1 negative), reflected in the negative outlook assigned to these issuers in February 2014.

However, Moody’s says some companies are well-positioned to accommodate lower returns. With fairly low gearing and strong interest coverage, United Utilities Water PLC (A3 stable) will be able to accommodate the lower returns with limited credit quality pressure. The credit ratings agency said other companies, including Severn Trent Water Ltd (A3 stable) would also enter the price review with financial headroom, but could face challenges in downside scenarios and were likely to have to adjust their dividend policy to maintain credit quality.

Companies can enhance return through margin on competitive non-household retail business

Moody’s  said that companies will be able to enhance their return through the margin on their competitive non-household retail business, but this is likely to be very small and the activities will be modestly riskier, as competition commences in April 2017. Companies may also be given scope to improve returns through outperformance under new incentive packages developed as part of the price review.

However, details of the potential and the timing of additional cash flow generation remain unknown at this stage. Moody’s is warning that the ability to enhance cash flow generation in the near term by front-loading cost recovery may increase liquidity but does not improve the fundamental credit quality.

Uncertainty still surrounds elements of the Price Review. Moody’s says that the timetable for the price review remains tight and despite advances on certain aspects of the determination, a lot of key details remain outstanding, particularly in relation to the total expenditure (totex) assessment and additional rewards and penalties as part of new incentive packages.

The report "UK Water Sector: Highly leveraged companies are most exposed to cuts in allowed returns" is available to buy or free to Moody's subscribers on www.moodys.com.