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COMMENTS

Credit FAQ: U.K. Utilities Are Feeling The Heat


Credit FAQ: U.K. Utilities Are Feeling The Heat

Regulators are bearing down on utility companies in the U.K., which are themselves responding to political pressure not only for lower prices for consumers but also improved service quality and higher environmental standards. However, the ratings on the U.K.'s water and electricity companies continue to benefit from S&P Global Ratings' view of low country risk and a strong regulatory advantage. This generally reflects a long and stable track record of independent regulation that allows for the full recovery of operating, capital, and financing costs, alongside strong ring-fencing conditions. Nevertheless, political, regulatory, and competitive pressures on U.K. utilities companies are gradually undermining their credit quality.

We recently downgraded the two largest energy supply companies, SSE PLC and Centrica PLC, mainly because business fundamentals have weakened. In addition, currently, seven out of 14 ratings on U.K. water companies carry a negative outlook, reflecting very high reset risk as we near the end of the current regulatory period in 2020 and as the regulator's review process for the next regulatory period enters its final stages. Although all of our ratings on U.K. energy (gas and electricity) networks carry stable outlooks at this point, we see a high likelihood that they could change once we reach the final stages of the review process for the next regulatory period for gas distribution and electricity and gas transmission networks starting April 2021.

Here, we aim to provide the market with an update of our views about trends in the U.K. water and energy sectors, especially regarding regulatory changes, briefly referring to articles we've published over the course of the past year (for the titles, see the Related Research section at the end of this article). We also address proposals by the Labour Party to renationalize U.K. utilities and how that could change our approach to rating them.

THE U.K. WATER SECTOR

What is S&P Global Ratings' view of the latest regulatory developments for the sector?

The U.K. water sector has reached the peak of regulatory reset risk, with the next regulatory period to begin in April 2020. We expect the next regulatory period to be challenging for water companies and as such we revised the outlooks on seven of our 14 ratings to negative.

The main goal of the regulator Ofwat for the next regulatory period is to provide better customer service at a lower cost, with a significant focus on operational performance and environmental impact. For the water companies, this means they will be seeing tighter financial ratios and potentially lower credit ratings.

An important element in the price methodology for the next period is the reduction in water companies' allowed cost of capital from about a real 3.4% to a real 2.3%, at an assumed retail price index (RPI) of 3%. Based on our preliminary forecast, this will lead to about an average 3% decrease in revenues across the sector between March 2020 and March 2021. Meanwhile, capital investment and total expenditure (totex) are likely to remain high, with many stringent regulatory requirements, including leakage reduction, lower service interruption, and better customer service. We forecast average capex across to sector to increase by about 10% between March 2020 and March 2021. As a result, we believe the worst performers in the sector will suffer.

What are the next steps in the regulatory review process and what does it mean for ratings?

All water companies have submitted their initial business plans and received initial feedback from Ofwat about their plans. The initial feedback fell into three buckets: fast track, slow track, and significant scrutiny. Of the companies we rate, two fell into fast track, three into significant scrutiny, and the rest achieving slow track (see table below). Fast-track companies already received a draft determination on April 11, with the remainder of companies to receive theirs by July 18. All companies will then receive their final determinations from Ofwat on Dec. 11, which will then come into effect on April 1, 2020. Between now and March 31, 2020, we will be in a position to form a view about the issuer credit ratings of each water company.

Table 1

Rated U.K. Water Utilities
Long-term issuer credit rating Outlook Initial Outcome
Northumbrian Water Ltd. BBB+ Negative Slow Track
Portsmouth Water Ltd. BBB Negative Slow Track
Severn Trent Water Ltd. BBB+ Stable Fast Track
South Staffordshire Water PLC BBB+ Negative Slow Track
United Utilities Water Ltd. A- Stable Fast Track
Sutton & East Surrey Water PLC BBB+ Stable Slow Track
Wessex Water Services Ltd. BBB+ Negative Slow Track
SED transactions and rating components
Financing group Rating on senior secured debt Rating on subordinated debt Initial Outcome
Affinity Water Programme Finance Ltd. A-/Stable BBB/Stable Significant Scrutiny
Anglian Water Services Financing PLC A-/Negative BBB/Negative Slow Track
Dwr Cymru (Financing) Ltd. A/Negative BBB+/Stable Slow Track
South East Water (Finance) Ltd. BBB/Stable -- Slow Track
Southern Water Services (Finance) Ltd. A-/Stable BBB/Stable Significant Scrutiny
Thames Water Utilities Cayman Finance Ltd. BBB+/Negative BBB-/Negative Significant Scrutiny
Yorkshire Water Services Finance Ltd. A-/Stable BBB/Stable Slow Track
Source: S&P Global Ratings.

U.K. ENERGY NETWORKS

What is S&P Global Ratings' view of the latest regulatory developments for the sector?

The next regulatory period, RIIO-2 (which stands for revenues = incentives + innovation + outputs), for the country's gas distribution and electricity and gas transmission networks will start in April 2021. The regulator Ofgem has now finalized the methodology it proposes to implement for the RIIO-2 price control process. RIIO-Electricity Distribution 2 for electricity distribution companies will come next and will be running from 2023 to 2028.

The main element of the new methodology is the reduction in the allowed cost of capital. Ofgem has adjusted its guidance for the baseline allowed cost of capital to about 2.9% of real consumer price inflation including house prices (CPIH), or 1.9% in real RPI terms. This compares to an estimated weighted average cost of capital ranging from 3.8% to 4.0% for RIIO-1 in real RPI terms as of March 2018 (see table 2). We expect this would reduce revenues, eventually eroding the limited headroom on the networks' credit ratios and increase pressure on the ratings on some networks.

Table 2

Cost Of Capital Allowance For U.K. Power Utilities: RIIO-2 and RIIO-1 Compared
RIIO-2 (average) RIIO-1 (as at March 2018)*
GD2, GT2, ET2 GD1 GT1 ET1
Cost of equity 4.8% (real CPIH) 3.8% (real RPI) 6.70% 6.80% 7%
Cost of debt 1.93% (real CPIH) 0.93% (real RPI) 2.22% 2.22% 2.22% (NGET/SPTL) 1.49% (SHET)
Notional gearing 60% 65% 62.50% 60% (NGET) 55% (SPTL/SHET)
Weighted average cost of capital 2.88% (real CPIH)§ 1.88% (real RPI)§ 3.79% 3.94% 4.13% (NGET) 4.37% (SPTL) 3.97% (SHET)
*Real RPI for inputs when applicable. §Baseline with cost of equity of 4.3% (CPIH) and 2.96% (RPI). CPIH--Consumer price inflation including house prices. ET--Electricity transmission. GD--Gas distribution. GT--Gas transmission. NGET--National Grid Electricity Transmission. RIIO-1—Shorthand for the regulatory period as of March 2018; the acronym stands for revenues = incentives + innovation + outputs). RIIO-2—The second regulatory period as of April 2021. RPI--Retail price index. SHET--Scottish Hydro Electric Transmission. SPTL--Scottish Power Transmission. Source: S&P Global Ratings.

Another important element in the new methodology is the proposal to use CPIH rather than the RPI as the inflation index for calculating regulatory asset value (RAV) indexation and the allowed return. This shift aims to protect consumers from the risk of rising prices over the next regulatory period. CPI has increasingly become the reference index to measure inflation, after RPI lost its status as a national statistic. The risk of the change in index, especially with no transition period being suggested by the regulator, would be a mismatch between the indexation of the company's revenues and RAV and that of its financial liabilities, since companies tend to issue significant amounts of long-dated, RPI-linked debt as part of their asset-liability management (about 30% of networks' debt is RPI-linked). This would be especially the case for companies with large shares of index-linked debt. We believe that some imbalance between assets and liabilities may arise in the short term if there is any deviation from the historical 1 percentage point difference between the two indices.

Chart 1

image

Finally, we also noted Ofgem's effort to balance the interests of consumers and investors by introducing new mechanisms to limit the potential for material outperformance or underperformance by individual companies. Ofgem acknowledges that some of the cost allowances for RIIO-1 were set too high, leading to outperformance on totex and high return on regulated equity (RORE) across the industry. In an attempt to balance the interests of consumers and investors, Ofgem proposes to introduce a return adjustment mechanism (RAM). We consider that the RAM may be supportive in a scenario of material underperformance, but they also prevent companies from earning excessive returns (for details about the mechanism see "Ofgem's Proposed RIIO-2 Regulatory Framework Will Test U.K. Energy Networks," published on Feb. 20, 2019).

As RIIO-2 will not begin until April 2021, it is too early to assess the credit impact on each company individually. Although all of our ratings on U.K. energy networks carry stable outlooks at this point, we see a high likelihood that they could change once we reach the final stages for the review process for the next regulatory period and specifically once the networks submit their business plans and receive the regulator's initial assessment in the first quarter of 2020.

Table 3

U.K. Network Companies And Ratings
Transmission utilities credit ratings
National Grid Electricity Transmission PLC A-/Stable/A-2
National Grid Gas Transmission PLC A-/Stable/A-2

SP Transmission Ltd.

BBB+/Stable/A-2

Scottish Hydro-Electric Power Distribution PLC

BBB+/Stable/A-2
Electricity distribution utilities

Northern Powergrid (Yorkshire) plc

A/Stable/A-1

Northern Powergrid (Northeast) Ltd.

A/Stable/A-1

Western Power Distribution (South Wales) PLC

A-/Stable/A-2

Western Power Distribution (South West) PLC

A-/Stable/A-2

Western Power Distribution (East Midlands) PLC

A-/Stable/A-2

Western Power Distribution (West Midlands) PLC

A-/Stable/A-2

Eastern Power Networks PLC

A-/Stable

South Eastern Power Networks PLC

A-/Stable

London Power Networks PLC

A-/Stable

Electricity North West Ltd.

BBB+/Stable/A-2

SP Manweb PLC

BBB+/Stable/A-2

SP Distribution PLC

BBB+/Stable/A-2

Southern Electric Power Distribution PLC

BBB+/Stable/A-2

Scottish Hydro-Electric Power Distribution PLC

BBB+/Stable/A-2
Gas distribution utilities

Cadent Gas Ltd.

BBB+/Stable

Northern Gas Networks Ltd.

BBB+/Stable

Scotland Gas Networks PLC

BBB+/Stable

Southern Gas Networks PLC

BBB+/Stable

Wales & West Utilities Ltd.*

Senior secured: A-/Stable; subordinated: BBB/Stable
*Corporate securitization transaction--Wales & West Utilities Finance PLC.

Energy Supply Companies Struggle With A Weak Operating Environment

Is there any upside for the supply sector in the near future?

Over the past two to three years, more challenging operating conditions have affected U.K. energy suppliers as a result of tougher competitive, regulatory, and political pressures, leading us to lower the ratings on two of the largest energy supply companies, SSE PLC (BBB+/Stable) and Centrica PLC (BBB/Stable).

After a long era of unchallenged oligopoly on the U.K. energy supply markets by the so-called Big Six (British Gas, SSE, E.On, Scottish Power, EDF Energy, and npower), smaller, more aggressive and agile new entities have gradually entered the market. They have eroded the dominance of the Big Six to a combined market share of 75%--their lowest ever--at the end of 2018 (see charts 2 and 3).

Chart 2

image

Chart 3

image

This move has nonetheless not been risk free for new entrants, and we have also seen a series of small players exiting the market in 2018-2019 on the back of inefficient hedging strategies and lack of scale to spread out the losses. As a result, the number of energy suppliers has kept on declining since its peak in June 2018 (see chart 4). This phenomena has been acknowledged by the regulator, which has made conditions for entering the market stricter.

Chart 4

image

In the meantime, political and regulatory pressure has weighed on the operating environment for the sector. Following a governmental pledge to drive energy bills down, Ofgem introduced the price cap for its first dual fuel cap level, effective for Standard Variable Tariffs (SVT) customers from January 2019. The tariff cap aims to give suppliers an incentive to improve efficiency and compete effectively for supply contracts. Margins in the supply market narrowed because of the cap, forcing companies to readapt their pricing strategies or increasingly seek cost efficiencies and innovations, or both. That said, Ofgem expects switching rates to decline by 30% following the introduction of the cap price, which could paradoxically suggest that competitive pressure is likely to ease in the short term, undermining the regulator's aim of fostering competition in the market.

We note that so far that neither the reduction in the number of energy suppliers nor the implementation of the tariff cap have led to a rebound in market shares and earnings for the Big Six (see chart 5). The increase in the price cap by about £100 in April 2019 after the implementation of the cap in January 2019 (see chart 6) may explain the continuation in the decline in market shares, with very high levels of switching from a now lower customer base.

Chart 5

image

Chart 6

image

Whether switching rates will continue at this pace remains unclear at this stage, and so is the future level of the price cap with the winter update. However, Paradoxically, a continuation in the substantial churn rate would suggest that the regulator met its objective in fostering competition. This could potentially justify its removal in 2020 at the earliest. The tariff cap was designed to be temporary, remaining in place at least until 2020 and up to 2023, depending on Ofgem's recommendation regarding a cap extension each year up to 2023.

However, such a scenario would imply that large U.K. energy suppliers will, in any case, continue to be affected by adverse operating conditions for the next one to two years. In addition, we believe that the price cap removal remains highly hypothetical given the relatively politicized level of discussion regarding the U.K. energy value chain, as we explain in this report.

Table 4

Credit Ratings On The Big Six U.K. Energy Utilities
Issuer credit rating, end-May 2019

Centrica PLC

BBB/Stable/A-2

E.ON U.K. PLC

BBB/Stable/A-2
EDF Energy PLC BBB-/Stable/A-3
npower PLC* BBB/Stable/A-2

Scottish Power Ltd.

BBB+/Stable/A-2

SSE PLC

BBB+/Stable/A-2
*Npower PLC is not rated; ratings in the table reflect those on its parent innogy SE. Source: S&P Global Ratings.

The Proposed Renationalization Of Utilities

In its May 2017 manifesto and in its recent publication in May 2019, Bringing Energy Home, the opposition Labour Party proposed to bring key utilities back into public ownership, thereby reversing the policy implemented by the Conservative government headed by then Prime Minister Margaret Thatcher to privatize more than 40 U.K. state-owned businesses during the 1980s. The objective of the policy that Labour proposes is to deliver better value to the public, lower prices, increase accountability, and develop a more sustainable energy system.

Such a reversal is not in our base cases at the moment. However, given ongoing political uncertainty and significant interest from investors about our view of the potential credit impact of renationalization, we present below some preliminary considerations.

What is included in Labour's renationalization plan?

In its May 2017 manifesto, Labour pledged to:

  • Bring private rail companies back into public ownership as their franchises expire.
  • Regain control of energy supply networks by altering the National and Regional Network Operator license conditions and transitioning to a publicly owned system.
  • Replace the water system with a network of regional publicly owned water companies.
  • Reverse the privatization of Royal Mail.

In its recent publication, which focuses solely on renationalization of the energy networks, Labour refers to bringing energy networks back into public ownership.

How does Labour intend to execute the plan?

According to Labour, the formal legal structure for bringing assets back into public ownership is an act of Parliament with two-step process, starting with transferring the assets back to public ownership and then setting the compensation to former owners, which would be financed by issuing treasury bonds. According to the recent paper, existing debts of the private companies will be carried over to the companies under public ownership and honored in full. We think legal constraints and disputes, in particular, relating to nationalization for less than full market value could still represent obstacles to implementing the policy, for example, potential legal battles with current shareholders who are likely to be unwilling to relinquish control. 

What are the costs associated with the plan?

According to Labour, the level of compensation should be determined by Parliament. A very rough estimate for the upfront costs associated with implementing the policy is between £140 billion and £160 billion, representing the regulated asset value (RAV; equivalent to the enterprise value) of water companies (£70 billion), gas and electricity distribution companies (£55 billion), and gas and electricity transmission companies (£20 billion). If Labour attempts to nationalize additional sectors, the costs could be significantly higher. However, we note that current market share and recent sales transactions have implied a high premium price for U.K. regulated utilities of up to 50% above the RAV, which could also be used as a basis for valuation. That would mean that the upfront costs could be significantly higher for the country. However, if Labour chooses to carry over the existing debt of the operating companies, the upfront costs could be lower.

The average debt-to-RAV ratio across the regulated water, gas, and electricity sectors is about 75% -80% on a consolidated basis--considering the debt at the operating company and holding company levels. This indicates that debtholders of the holding company benefit from some degree of security if renationalization is executed based on RAV. Nevertheless, holding company creditors rank second to those at the operating company and the bulk of the debt is concentrated at the operating subsidiaries (operating companies typically operate at about the notional leverage). We therefore believe that holding company debtholders are more exposed to a renationalization policy, especially when considering deductions on the basis of, for example, pension deficits, asset stripping, and stranded assets.

What would be the credit impact of renationalization?

If the Labour party did succeed in moving privately held utilities back into public ownership, we may begin to rate the utilities as government-related entities (GREs). Our general analytical approach to rating GREs is to consider their credit quality as falling between the inclusive bounds formed by the GRE's stand-alone credit profile (SACP) and the sovereign rating. Any uplift from the SACP depends on our opinion of the likelihood of sufficient and timely extraordinary government intervention in support of the GRE meeting its financial obligations, an opinion we derive from our assessment of the GRE's role for and link with the government.

Whether the GRE approach is a negative or positive rating factor depends on the relative strength of the entity on its own versus that of the sovereign that supports it. Therefore, the rating impact of a renationalization of utility companies would also depend on the impact of renationalization on the rating on the U.K. (AA/Negative/--). We don't have any visibility about what would be the impact, as on the one hand, renationalization might increase the country's debt, but on the other hand, utility companies generate cash flows that can be distributed to the government in the form of dividends.

We assess U.K. regulated utilities as benefiting from one of the best regulatory frameworks in Europe, and we believe that financial stability is supported by the sectors' proven and uninterrupted access to the capital markets, even during periods of stress. There are significant uncertainties about how the utilities would be managed after a renationalization, whether it would impact their regulatory framework and whether a renationalization policy would hinder the attractiveness of the sector for investors.

Writer: Rose Marie Burke

Related Research

  • United Kingdom Ratings Affirmed At 'AA/A-1+'; Outlook Remains Negative, April 26, 2019
  • Ofgem's Proposed RIIO-2 Regulatory Framework Will Test U.K. Energy Networks, Feb. 20, 2019
  • New Ofwat Regulations Will Keep U.K. Water Utilities On Their Toes, Jan. 30, 2018
  • How Regulatory Reset, Brexit, And Other Political Risks Weigh On U.K. Utility Ratings, Dec. 12, 2018

This report does not constitute a rating action.

Primary Credit Analyst:Matan Benjamin, London (44) 20-7176-0106;
matan.benjamin@spglobal.com
Secondary Contacts:Beatrice de Taisne, CFA, London (44) 20-7176-3938;
beatrice.de.taisne@spglobal.com
Pierre Georges, Paris (33) 1-4420-6735;
pierre.georges@spglobal.com
Julien Bernu, London + 442071767137;
Julien.Bernu@spglobal.com
Gustav B Rydevik, London + 44 20 7176 1282;
gustav.rydevik@spglobal.com
Additional Contact:Industrial Ratings Europe;
Corporate_Admin_London@spglobal.com

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