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Political pressure and Brexit risk weigh on UK utilities, S&P Ratings says

Political pressure and Britain's impending exit from the European Union could have a negative effect on the credit ratings of electricity, gas and water utility companies in the U.K., despite the country's status as one of the most favorable regulatory environments in Europe, S&P Global Ratings analysts said in a new report.

Energy suppliers have seen their business prospects undermined by the introduction of a tariff cap, which could particularly hurt the biggest power and gas providers, Centrica PLC and SSE PLC, while regulatory reset risk is on the rise for water companies as the review process for the next regulatory period comes to an end, according to the Dec. 12 report.

The government's energy price cap has already made waves ahead of its planned implementation next month.

Centrica, which respectively captures approximately 30% and 20% of Britain's power and gas supply markets, announced in November that up to 3.5 million of its customer accounts would be affected by the price cap, costing the company an expected £70 million in the first quarter of 2019. Meanwhile, SSE and Germany's Innogy SE have been renegotiating a proposed merger of their U.K. retail businesses because of the cap, prompting Innogy's CFO to suggest last month that the deal could yet fall apart.

"The implementation of the cap highlights in our view the significant level of political scrutiny that the U.K. energy retail sector faces, and the likely financial challenges this could pose," the S&P analysts wrote in their report, noting that Britain's so-called Big Six suppliers have a higher share of customers on the most expensive default tariffs regulated by the cap than their smaller competitors.

Competition in the U.K. energy supply sector has intensified in recent years, as the government's Office of Gas and Electricity Markets, or Ofgem, lowered entry barriers for new companies. The Big Six, which also include Innogy subsidiary NPower, Germany's E.ON SE, French state-controlled Electricité de France SA and Iberdrola SA subsidiary Scottish Power, still hold around three-quarters of the market but have seen their market share decline by between four and five percentage points on average during the last five years, according to Ofgem.

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One positive factor of the tariff cap for those companies is an actual projected decline in switching rates, since consumers will have less incentive to ditch expensive rates. "We believe the price cap could improve industry competitive condition in the long run," Jia Man Neoh, an analyst at CFRA Equity Research, said in a note to clients in November.

Another element that could reduce competition is a more stringent licensing regime, announced by Ofgem after the default of a list of small suppliers in 2017 and 2018 mainly due to rising wholesale prices, the S&P analysts said. The largest, Spark Energy, supplied 280,000 customers.

Water utilities in England and Wales are meanwhile bracing for a new pricing methodology from the Office of Water Services, or Ofwat, due at the start of the next regulatory period in 2020.

"In our view, the greatest repercussions will come from a reduction in the allowed cost of capital and the introduction of more rigorous benchmarks on cost efficiencies and service performance," the S&P analysts said. "As such, water utilities' credit metrics could weaken to the extent that we take negative rating actions, especially in the case of the more inefficient and highly leveraged utilities that will be in a weaker position to adapt to the changes."

Brexit risk

A sudden Brexit could cause a prolonged period of market volatility for utilities, reducing liquidity and increasing regional risk, the report said. The U.K. and the EU have agreed on a draft withdrawal treaty, but the possibility of a no-deal Brexit has increased significantly in recent weeks as U.K. Prime Minister Theresa May is struggling to get her deal through a fractured parliament.

Funding costs are also likely to go up as a result and Brexit could additionally reduce access to funding from the European Investment Bank. "Once the U.K. ceases to be a member of the EU, it is likely that the EIB will curtail new lending in the U.K. significantly, from a historical level of about €1.8 billion in 2017 and €6.9 billion in 2016," the report notes.

Since most utilities in the U.K. have little business outside the country and some enjoy monopoly status, Brexit is unlikely to have an immediate material impact on the stand-alone credit quality of rated utilities, however, the analysts said.

S&P Global Market Intelligence and S&P Global Ratings are owned by S&P Global Inc.