A paper commissioned by Thames Water to explore credit risks which could arise as a result of the introduction of competition in the water sector has found that it could impact future investment.

The paper, by FTI Consulting LLP, says that the current situation whereby the water companies collect their revenues directly from end-customers i.e. businesses and households may change with the advent of competition in the non-household water retail market from April 2017. The government is also considering whether to open the household water retail market in England to competition at some later (yet-to-be-determined) date. Ofwat has been requested to make an assessment of the costs and benefits of opening the household retail water market in England by summer 2016.

FTI says that introducing competition into the household water retail market has the potential to change the risk profile of investing in English water companies. The paper states:

"Companies' credit ratings, which influence the cost at which they can raise debt, are influenced by counterparty credit risks (i.e. the likelihood that the company will be able to collect its revenues from the entities it sells its services to). In turn these risks could increase or decrease as a result of changing water companies' counterparties from end-customers (e.g. households) to retailers."

According to FTI, if the probability of household retailers defaulting on their obligations to water companies, or the losses which water companies could incur if defaults do occur, are too high, then this could increase water companies' counterparty credit risks, or the perception of those risks by credit rating agencies. The credit ratings of water companies could be negatively affected as a result, the paper warns.

The paper is flagging up the importance of understanding the potential for counterparty credit risk to increase as a result of opening the household water retail market at some future date and whether any increase in risk could be mitigated through the design of the future market or regulatory arrangements applied to the sector.

FTI Consulting LLP has explored the following two key issues in the paper:

1. whether a material amount of incremental counterparty risk could be introduced as a result of expanding retail competition to include household customers; and

if so, whether there are options available to address those risks (such as mechanisms for mitigating or compensating those risks) which would be consistent with the water industry's objectives e.g. providing value for money services for customers

2. Could a material amount of incremental counterparty risk be introduced as a result of expanding retail competition to include household customers?

The paper says that whether the opening of the household water retail market would be likely to increase counterparty credit risks depends on the following factors:

• whether the current regulatory and legislative arrangements could continue to provide effective protection against counterparty credit risks in future;
• whether the probability of default of water companies' counterparties would increase;
• and whether the losses given default of one or more of water companies' counterparties would increase.

Addressing whether the existing regulatory and legislative arrangements will continue to provide effective protection in future, says the measures, viewed collectively, currently provide the industry with some degree of protection against bad debt risks, although "the residual risk borne by companies is not trivial."

However, if the household retail market was opened to competition, the paper is warning that the associated regulatory modifications may result in the loss of some of the current regulatory protections. In a future household water retail market, water companies' counterparties would be household retailers. The water companies' credit ratings will depend on the creditworthiness (or credit rating agencies' perceptions of the creditworthiness) of household water retailers.

According to FTI, the creditworthiness of these retailers in a future household water retail market is difficult to assess directly in the absence of any observable real world examples of household retailers operating in the English water sector. The paper says a number of pieces of evidence enable inferences to be drawn about the likely creditworthiness of household water retailers, including the fact that no "pure-play stand-alone retail business" in the British, Texas, Californian, New York or Australian energy or British water markets has an investment grade credit rating. FTI says this suggests that it is difficult for these types of businesses to achieve an investment grade credit rating;

The paper also makes the key point that when the Scottish non-household water, British gas and electricity, and UK telecoms (local loop) retail markets have opened to competition, market arrangements have required retailers to either achieve a strong investment grade credit rating or post collateral of various kinds.

"It may be appropriate to be concerned about the potential creditworthiness of new entrants into an English household water retail market in future"

"This suggests that it may be appropriate to be concerned about the potential creditworthiness of new entrants into an English household water retail market in future", the paper says.

FTI has also drawn attention to "numerous examples" of retailers defaulting in other de-regulated sectors in the past, such as Aquavitae in the Scottish non-household water retail market or Independent Energy in the gas and electricity supply markets, commenting:

"While there may be differences in the risks of retailing in different sectors, this suggests that new entrant retailers operating in the English water sector could also potentially default."

It also says that the aspects of the existing regulatory regime applied to English water companies which credit rating agencies have identified as supporting water companies' credit ratings (e.g. RCV, revenue stability, regulatory track record) may be less applicable to the household water retail market.

The paper also suggests that the default of a household water retailer in a future competitive market could result in material losses.

Credit rating agencies typically regard companies with a diversified customer base more favourably than those with a concentrated customer base, all else equal.Consequently, if a water company receives an increasing proportion of its revenues from a single counterparty (e.g. a retailer serving several thousand customers), it is exposed to a larger potential loss than if it is interacting directly with individual end-customers - which may be negative from a credit risk assessment perspective.

The paper says:

"The value at risk in the event of a retailer default could be material: since household retailers will collect around 80% of water companies' revenues (with the other 20% of revenues coming from non-household retailers), the revenues which would be lost in the event of a retailer default would be material."

"Given this 80%/20% split between household/non-household revenues, incumbent water companies would face counterparty credit risks in the household market approximately four times higher than the non-household market, all else equal."

"Taken together, these factors suggest that the losses incurred by water companies in the event a household water retailer defaulted would be material."

The paper sets out a number of arrangements which could be put in place to mitigate the risks and measures aimed at reducing the probability of default, such as:

• tests of the financial strength of retailers;
• requirements on retailers to pre-pay wholesalers;
• enabling wholesalers to mitigate risks through commercial negotiations with retailers;
• measures aimed at reducing the loss given default, such as:
• requirements on retailers to post collateral against amounts they owe (or are expected to owe) wholesalers;
• joint liability amongst retailers for amounts due to wholesalers;
• supplier of last resort (SoLR) arrangements;
• revenue correction mechanisms (RCMs);ex-ante bad debt allowances included in wholesale price controls;
• bad debt true-ups or pass-throughs within wholesale price controls;
• funding the costs of water companies buying protection against retailer defaults;

FTI also examines how well each potential mitigation measure delivers wholesalers' and retailers' objectives.

Click here to download the paper