- After four U.K. water utilities appealed the regulator's final determination for 2020-2025, the Competition and Markets Authority (CMA) this week released provisional findings that we consider generally credit positive.
- That said, the three rated utilities affected will need to take additional measures to support their credit metrics, if they are to maintain the current ratings.
- We will review our ratings in early 2021, after we have reviewed the CMA's final decision and the plans from the three rated companies.
The Competition and Markets Authority's (CMA) decision regarding water regulator Ofwat's 2020-2025 price controls may not affect many of the 17 U.K. water utilities, but Ofgem, the U.K. power and gas network regulator, uses similar parameters to determine the weighted-average cost of capital (WACC). The CMA's decision could therefore be a positive signal, given that Ofgem will release its determination for the upcoming regulatory period by year-end 2020.
The CMA published its provisional findings on Sept. 30, 2020, and targets December 2020 to send its final determination (FD) to Ofwat. Only the four water utilities--Anglian, Bristol, Northumbrian, and Yorkshire--that asked for their FDs to be referred to the CMA will be affected. The 13 other U.K. water utilities will continue to operate according to the 2020-2025 price controls published in Ofwat's FD in December 2019. Therefore, they will not benefit if the CMA's final decision retains the substantial increase in allowed return published in the provisional findings.
Anglian, Bristol, Northumbrian, and Yorkshire chose to challenge Ofwat's FD on two key elements:
- The allowed remuneration, which had been diminished by the low WACC used to remunerate the regulated asset base (RAB); and
- The total expenses (totex) that utilities are allowed to spend over the regulatory period, which was seen as insufficient to fulfil their mission and service quality requirements.
After Ofwat released its FD in December, we took various negative rating actions on companies across the sector (see "Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative," published on Feb. 25, 2020). All ratings on the utilities that appealed to the CMA are either on CreditWatch with negative implications, or have a negative outlook (see table 1).
|Ofwat's Final Determination Caused Negative Rating Actions|
Anglian Water Services Financing PLC
|Senior Secured||A-/Watch Neg|
|Secured Subordinated Debt||BBB/Watch Neg|
Northumbrian Water Group Ltd.
|Issuer Credit Rating||BBB+/Watch Neg/--|
Yorkshire Water Finance PLC
|NB: This list does not include all the ratings affected.|
In all three cases, we saw a material risk that implementing the regulatory determination would cause credit metrics to deteriorate significantly unless the utility took other remedy measures.
The main element of the CMA's provisional determination is the substantial increase in allowed return, to 3.50% from 2.96%. Drilling down, we see that CMA has changed the parameter definitions used to determine the WACC from those used by Ofwat (see table 2). The result is a higher cost of equity given higher total market return, a higher risk-free rate, and a higher equity beta.
|Changes To Certain Parameters Altered CMA's WACC Estimate|
|(%)||Ofwat price review 19||CMA Point Estimate|
|Cost of new debt||0.53||0.37|
|Cost of embedded debt||2.42||2.76|
|Proportion of new debt||20||17|
|Pre-tax cost of debt||2.14||2.45|
|Post-tax cost of equity||4.19||5.08|
|Appointee-level vanilla WACC||2.96||3.50|
|CMA--Competition And Markets Authority. WACC--Weighted-average cost of capital.|
In response to the second aspect of the utilities' challenge, the CMA decided to increase totex allowances for all four companies, reducing the gap between the regulator's view and the companies' estimate of efficient costs to be incurred over asset management period 7 (AMP7; covering 2020-2025) to deliver its business plan. Those changes include:
- £144 million increase for Anglian;
- £93 million for Yorkshire; and
- £22 million for Northumbrian.
The CMA has also removed the gearing outperformance sharing mechanism, which was initially introduced to share the benefit of high gearing with customers. The CMA disputes the effectiveness of the mechanism in improving financial resilience.
We anticipate that the provisional findings would support the respective companies' credit metrics over AMP7. Our high-level estimates suggest that the increase in WACC would, for example, lead to an increase in annual revenue of £25 million-£45 million, on average, for Anglian, Northumbrian, and Yorkshire Water over AMP7.
Nevertheless, we remain aware that these findings are still provisional. The fully finalized business plan under which each group will operate is unlikely to be available until the first quarter of 2021, considering that the CMA targets December 2020 to send its FD to Ofwat.
More importantly, in our view, these companies are operating with limited headroom or below the level we see as commensurate with their current ratings and will likely continue to do until March 31, 2021, using Ofwat's FD (prior to CMA revisions) for the first year of AMP7. As a result, their ratings are on CreditWatch negative or have a negative outlook. Although credit metrics could improve, compared with the projections we based on inputs from Ofwat's FD, we still expect these U.K. water networks to face tougher operating conditions in AMP7 than in the current regulatory period, like the rest of the sector. The ratings remain under strain.
The Next Steps
Now that the CMA has published the provisional determination, the water companies and other third parties are invited to respond to the provisional determination by Oct. 27. The CMA will analyze this feedback by mid-November. It plans to send its FD to Ofwat in early December 2020.
Once we have reviewed the CMA's FD in detail and have discussed any potential mitigating plans with the companies that appealed, we will be in a better position to assess the credit impact on the companies. Even though we see the provisional determination as a positive outcome for the companies, we still anticipate that the companies will need to take other actions to maintain their credit standings. We expect to resolve the outstanding CreditWatch placements in the first quarter of 2021, as companies' actions and performance become clearer.
Other Regulated Sectors Will Examine The CMA Findings
The CMA findings will be an interesting data point for the U.K. power and gas network regulator, Ofgem, as it makes a decision on the final determination for gas and electricity transmission networks and gas distribution network later this year. Although the CMA's findings are generally positive for the networks, particularly the findings on allowed return, we recognize that the energy industry faces different challenges and different types of risk (see "Various Rating Actions Taken On U.K. Gas Networks Amid Upcoming Regulatory Review And Tougher Operating Conditions," published on April 30, 2020). As a result, we cannot say how the CMA findings will affect the FD for energy networks.
- Various Rating Actions Taken On U.K. Gas Networks Amid Upcoming Regulatory Review And Tougher Operating Conditions, April 30, 2020
- Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative, Feb 25, 2020
- Why We See The Regulatory Frameworks For U.K. Utilities As Supportive, Sept. 26, 2017
This report does not constitute a rating action.
|Primary Credit Analysts:||Matan Benjamin, London + 44 20 7176 0106;|
|Gustav B Rydevik, London + 44 20 7176 1282;|
|Julien Bernu, London + 442071767137;|
|Secondary Contacts:||Beatrice de Taisne, CFA, London (44) 20-7176-3938;|
|Pierre Georges, Paris (33) 1-4420-6735;|
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