Moody's Investors Service has maintained its stable outlook for business conditions in the UK water sector over the next 12 to 18 months – however the ratings agency is warning of long term challenges ahead beyond 2016.

In its Industry outlook 2016 report "Stable outlook – calm waters ahead of the storm? ",  Moody’s says achieved returns for the last regulatory period were broadly in line with regulatory assumptions.  However, the non-household retail market will be opened to competition in April  2017, alongside other challenges with Ofwat considering potentially significant upstream reforms from 2020.

 Stefanie Voelz, Moody's Vice President -- Senior Analyst said:

"While companies will have less scope for operational and financial outperformance over the coming five years, we anticipate they will manage their financial and dividend policies to maintain credit quality."

 The report also notes:

• Recent performance in line with expectations for the expiring regulatory period and the cut in allowed wholesale returns to 3.6% for the new regulatory period, which began in April 2015, was in line with Moody’s expectations, and reflects the low interest rate environment.
• Final price determination for the current regulatory period (2015-20) remains challenging as significantly lower allowed returns will reduce companies’ ability to outperform on financing costs.
• Moody's notes that the highly-leveraged water companies remain most exposed to the lower return allowance in the current regulatory period, as well as ongoing developments within the sector.

The opening up of the non-household retail market, which accounts for just 1-2% of companies' revenues, will not significantly alter the sector's credit risk profile. However, further regulatory reforms affecting upstream activities such as water resources and water and wastewater treatment may have a significant impact if and when they take effect after 2020.

Aside from the partial introduction of competition, Moody’s said other changes contemplated by Ofwat, such as a change in the benchmark index used to inflate the UK water companies' RCV and revenues to the consumer price index (CPI) from the retail price index (RPI), may also have negative credit implications.

Moody’s said that United Utilities remains among the few companies that may still achieve financing cost outperformance due to its relatively low funding costs when compared with the sector average. Otherwise, companies that saw limited regulatory challenge to their plans, including Dwr Cymru Welsh Water, Northumbrian Water and the two enhanced companies, Affinity Water and South West Water will have the greatest scope to generate savings against the total expenditure (totex)allowances set by the regulator.

In contrast, highly-leveraged companies, including Affinity Water, Anglian Water, Thames Water, Southern Water and Yorkshire Water remain most exposed to the lower return allowance in the current regulatory period, as well as ongoing developments within the sector.

With higher gearing and lower interest cover than peers, Moody’s is warning that these companies have less flexibility to accommodate downside scenarios and that creditor protections incorporated within their financing structures may not be effective to maintain their credit quality in the face of significant reform.

The ratings agency said the opening up of the non-household retail market in April 2017, which accounts for just 1-2% of companies' revenues, will not significantly alter the sector's credit risk profile. However, further regulatory reforms affecting upstream activities such as water resources and water and wastewater treatment may have a significant impact if and when they take effect after 2020.

Moody’s said the sector outlook could turn negative if companies are unable to earn at least the allowed return of 3.74% p.a. (including the retail margin) for the current five-year regulatory period. While unlikely, the sector outlook could turn positive if companies are able to significantly outperform their final price determination, and earn returns materially in excess of the 3.74% allowance.

In the longer term, the sector’s credit quality may also be negatively affected by Ofwat’s potential future upstream reforms. The regulator has highlighted sludge treatment and disposal as well as water resources as the parts of the value chain most likely to benefit from increased competition. Moody's says that while these areas may affect the industry only modestly, the regulator does not exclude other forms of competition for the market, i.e. open tenders for investment into new treatment works or reservoirs.

"UK Water Sector - Industry Outlook 2016: Stable outlook -- calm waters ahead of the storm?" is available at www.moodys.com.

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