Earlier this week, the U.K. water utility regulator Ofwat completed the final stage of the price review process (PR19) for the next regulatory period (lasting through March 2025), by publishing its final determination for water companies in England and Wales. Ofwat's stated chief goals are to provide customers with better service at a lower cost, with significant focus on operational performance and the environmental impact.

S&P Global Ratings believes, in line with its previously stated views on the matter, that the final determination does not bode well for the credit quality of the country's water utilities. Our preliminary assessment of the final determination reinforces our early view that the next regulatory period will be challenging for water companies. This weakens the sector's overall credit quality. Companies with the highest leverage are logically most affected by the lower remuneration, given their higher sensitivity to WACC reduction. Those who already had little or no headroom under their current rating also face challenges. It's not all bad news for companies, however. Several companies have received some relief through the pay-as-you-go (PAYG) mechanism, and cost allowances aren't quite as strict as was the case in the draft determination.

Water companies have until Feb. 15, to decide if they want to appeal. In the next few months, we will review the ratings on the 14 companies we rate in the industry--and the likelihood of downgrades for the majority of them is relatively high.

Key Factors In Ofwat's Final Determination

The current price control period for water companies in England and Wales ends March 31, 2020. Under PR19, water companies create their business plans for the next regulatory period from April 2020 to March 2025, based on the regulator's methodology and under its supervision. The regulator assesses and tests the business plans submitted by the companies before determining the final price, cost allowance as well as service and incentive package for each company.

We have continuously stated over the last two years, as PR19 progressed, that the next regulatory period will be challenging and as a result, have negative outlooks on 11 of our 14 rated water companies.

Our preliminary assessment of the final determination reinforces this early view. The regulator has reiterated its chief goal for the next regulatory period is to provide customers with better service at lower costs with significant focus on operational performances and environmental impact. Water companies will earn lower returns while being required to maintain high levels of efficiency, as they strive to meet demanding regulatory targets around leakage reduction, lower service interruption and improved customer service. Furthermore, the range for rewards and penalties pertaining to outcome delivery incentives (ODIs) is skewed to the downside, representing significant risk particularly for the worst performers. We expect lower returns and higher operating standards to result in tighter financial ratios--and possibly lower ratings.

At the same time, the regulator has adjusted its guidance (compared to the draft determination in July) on PAYG and cost allowances for a few companies, which somewhat boosts cash flows generation in the near term and could protect credit metrics to an extent.

What are the next steps in the regulatory process?

All companies have now received their final determinations from Ofwat. If they do not appeal by Feb. 15, 2020, the determination will take effect April 1 (see chart 1). We will assess the credit impact on individual companies once we review in detail the determination and discuss any mitigating plans with the companies. We expect to take rating actions early in 2020.

Chart 1

Credit Metrics Are Set To Take A Hit

Our preliminary assessment of water companies' forecast model under the final determination indicates that credit ratios will weaken to the extent that they might fall below ratings thresholds for most of the companies (see chart 2).

Chart 2

Ofwat indicates a further reduction in weighted-average cost of capital

Under the final determination, Ofwat indicates that from April 2020, water companies' allowed cost of capital will fall to 1.92% from about 3.40% in real terms, at an assumed retail price index rate of 3%. This represents a further 16 basis-point reduction versus the July guidance. The revised guidance reflects the lower market cost of debt and the shift in equity market conditions (cost of equity of 3.18% compared with 5.40% from the previous final determination [PR14; see table 1]), and it generally signals the regulator's push toward more affordable bills.

Table 1

Range for rewards and penalties pertaining to ODIs is skewed to the downside, but less so compared with the draft determination

Under the final determination, Ofwat increased the proportion of revenue at risk from service performance through ODIs. The average ODI return on regulated equity (RoRE) risk ranges from positive 1.3% to negative 1.9% (see chart 3). A small negative skew remains, but less so compared to the significant negative skew at PR14 (negative 1.7% to positive 0.6%). Although the range is less heavily weighted to the downside, the targets are tougher and will most likely lead to sizable penalties for weaker performers.

However, Ofwat has introduced a wide range of targets, meaning that just because a company receives penalties in one category doesn't mean it will be necessarily do so across the board and might be able to partially offset some penalties with rewards. The most significant contributors to the reduced downside and increased upside on the ODI RoRE range come from incentive changes for water supply interruptions, leakage and internal sewer flooding.

During PR14, when the average range of rewards and penalties was negative 1.7% to positive 0.6%, companies still managed to deliver on average 0.1% of reward. This indicates that if companies focus on their performance commitments and customer service, they will likely still receive net rewards during the upcoming period.

The final determination ODI RoRE risk range represents a certain improvement from the draft determination when they were set at negative 2.6% to positive 0.7%. This shows that Ofwat considered some of the arguments the companies presented in their responses to the draft determination.

Chart 3

Adjusting PAYG Expenditure Can Boost Cash Flow In The Near Term

Companies can recover their costs in the year they are incurred through PAYG, or added to the regulated capital value (RCV) and recovered over longer periods through the RCV depreciation. Balancing the recovery methods can aid utilities manage their leverage, especially considering that companies must consider customers' views and the effect on the bill in their decisions.

Therefore, in changing their bill profile, and increasing the PAYG rate, water companies are bringing forward revenue, which can help temporarily boost credit metrics (although this means the company will forgo some of the growth it forecasts in RCV).

Despite a material decrease in PAYG with regards to the previous regulatory period with PAYG declining by approximately 7 percentage points, we believe that some companies will be able to rely on this lever to protect their credit metrics. Between the draft and final determinations, for instance, the PAYG has increased by an average of about 3.5 percentage points notably benefiting Yorkshire Water (8.0 percentage points), Welsh Water/Dwr Cymru (6.3), and South Staff Water (6.0).

Chart 4

Companies Face A Large, If Slightly Lower, Variance In Totex

Totex allowance for companies is composed of two main components; base costs and enhancement costs. Ofwat assesses these two items separately. Base costs are generally required for ongoing business operation and Ofwat use econometric models to benchmark cost performance among companies in order to enhance efficiency. Enhancement expenditure relates to investment to enhance service beyond a base level. The regulator also scrutinizes these costs.

The totex has been a large point of contention for many of the water companies in their responses to Ofwat following the draft determination. Considering that companies will have tough ODI targets as well as lower returns, totex will be very important for companies to sustain adequate performance and avoid penalties.

The average overall totex variance between companies' August representation and the final determination represents a 4% efficiency on the company representations (see chart 5). The highest variance was for Anglian, with 12%, and the only company to submit a more efficient plan than Ofwat was Portsmouth Water whose plan was 8% more efficient than Ofwat's view. These gaps will increase the risk of potential cost overruns for the water companies, although any overruns will be split evenly between companies and customers.

With Ofwat providing roughly 3% more in the final determination than the draft one, we believe that, with the rest of the determination being very tough, this slight boost in totex will give companies a little bit of protection for their performance. It is now up to the companies to use their allowed totex as effectively as possible.

Chart 5

Chart 6

Table 2

What To Expect From Us

We anticipate being in a better position to assess the credit impact on individual companies once we review in detail the determination and after having discussed any potential mitigating plans with the companies. We expect to take rating actions early in 2020 as companies' actions and performance in the new regulatory period become clearer. Companies have limited flexibility to mitigate the expected negative impact because they are unlikely to outperform on totex or benefit from material rewards and they have already reduced dividends.