Ratings agency Fitch is warning that the UK water regulator's new approach to setting price controls reduces earnings visibility and is likely to put pressure on some credit ratings.
Ofwat has indicated that for the upcoming tariff settlement, which will set water bills for 2015-2020, support for credit investors has been reduced to investment grade, or 'BBB-' and above, in line with licence requirements. The regulator previously targeted solid investment grade 'A-' or 'BBB+' ratings for the capital-intensive water companies.
Among the main changes from the previous price review is a sharp drop in the guidance for weighted average cost of capital to 3.85% (from 5.1%) and an increasing proportion of earnings from incentives. Fitch said the reduction of the cost of capital to 3.85% was sharper than expected and the emphasis on incentives reduces earnings visibility.
The ratings agency said it is now reviewing the ratings of the more highly leveraged transactions and related unregulated holding companies, where the impact will be greatest, and will take “any necessary initial ratings action” in the coming weeks.
Fitch said its initial analysis indicates that reduced earnings will have a material impact on post-tax and post-maintenance interest cover ratios, and that these are likely to be a limiting factor for ratings under the new price regime.
The ratings agency added that in the coming months it will be important to assess how challenging cost targets for total expenditure will be, saying that some companies may be able to narrow the earnings gap through outperformance in this area.
Fitch’s Special Report "UK Water Sector Faces Material Reduction in Earnings", published today, considers the potential impact of Ofwat's pricing review, including a comparison of the Ofwat process with the gas regulator Ofgem's gas distribution price controls. The report is available from www.fitchratings.com.
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