U.K. utilities are facing a unique set of challenges. Decarbonizing operations and staying buoyant amid the COVID-19 pandemic are worldwide concerns, but U.K. utilities also have regulatory obstacles to overcome and the effects of Brexit to consider. Four water utilities are in the process of appealing Ofwat's final determination (FD), while energy companies are still digesting the recently published FD from Ofgem. Nevertheless, so far, U.K. utilities have proved resilient to the challenges posed by the pandemic, and they continue to benefit from a supportive regulatory environment. In this report, S&P Global Ratings delves the likely credit impact of macroeconomic and regulatory events on the various U.K. utilities sectors.

Ofgem's Final Determination

The FD is a positive development, but might not be enough for all networks

Last week, the energy regulator Ofgem published its FD for electricity and gas transmission companies and gas distribution companies in Great Britain. It marks a key step in the review process for the next regulatory period beginning in April 2021.

Several elements of the FD are supportive compared with the draft determination (DD) published in July this year, particularly the increase (about 20 basis points [bps]) in the weighted-average cost of capital (WACC) and an increase of about 25% in total expenditure (totex) allowances compared with the DD.

Despite these positive developments, we continue to think that the next regulatory period will be challenging for most U.K. energy networks. Furthermore, our preliminary assessment of the FD indicates that some networks will need to take additional measures to support their credit metrics if they are to maintain the current ratings. These might need to go beyond a temporary dividend cut to mitigate the lower regulated revenues. We currently have negative outlooks on three networks to reflect this downside risk: Wales & West Utilities (WWU; issue ratings), Scotland Gas Networks PLC and Southern Gas Networks PLC (together SGN), and National Grid (NG). We expect to be in a better position to assess the credit impact on individual companies in early 2021 after reviewing the determination in greater detail. We will also discuss with issuers the ramifications of the FD and their responses to it, including potential appeals to the Competition and Markets Authority (CMA), as seen in the water sector this year.

Drilling down into the FD

Under the final determination, Ofgem, the gas and electricity regulator, has indicated about an 18 bp increase in WACC compared to the DD. The increase in WACC still represents a significant reduction compared to the current regulatory period. The WACC for RIIO-2 (revenues = incentives + innovations + output) is the lowest ever seen by distribution networks in the U.K., with the baseline return down to 2.81% in RIIO-GD2 from 3.79% in RIIO-GD1 (see table 1); the 2.81% WACC also applies to gas transmission. SGN Scotland, Northern Gas Networks, and WWU receive a 6 bp boost to return on debt resulting in a 4 bp increase to WACC (2.85%) following their evidence regarding the potential risk that smaller networks face on borrowing costs. On the electricity transmission side, WACC for RIIO-T2 is 2.69% for Scottish Hydro Electric Transmission (part of SSE, 'BBB+/Stable') and 2.81% for National Grid Electricity Transmission & Scottish Power Transmission (see table 2). The expected outperformance wedge of 0.25% included in the DD remains in the FD, because Ofgem expects certain information asymmetry between business plan submissions and actual expenditures, following large totex outperformance in RIIO-1. At the DD stage, the outperformance wedge was to be an ex-post adjustment based on the sector average, whereas in the FD, Ofgem changed it to be licensee-specific. Overall, the decrease in WACC from RIIO-1 to RIIO-2 will represent a significant challenge for the companies and demonstrates the regulator's determination to provide affordable bills for customers.

Table 1

Table 2

Mind the gap

The totex gap reduced under the FD, but for some of the networks it still falls short of the initial request. Overall, baseline totex for gas distribution networks (GDNs) and transmission operators (TOs) under the FD compared with the DD increased by about 25% to £20.3 billion (£9.6 billion for GDNs and £10.7 billion for TOs), and the aggregated amount across the TOs and GDNs is higher than the actual average run rate for all networks combined in RIIO-1. The increase for GDNs and TOs reflects the correction of technical errors, volume adjustments, additional allowance pertaining to IT, and capital expenditure (capex) workload based on new evidence and adjustment to the cost-efficiency challenge. While additional totex under the FD should enhance companies' performance, we note that baseline totex for several companies remains lower than the amounts requested in their business plans submitted in December 2019, particularly for National Grid, SGN, and Cadent. As a result, it is unclear whether networks will view the allowed totex under the FD as enough to deliver the required level of resiliency, reliability, and growth. Ultimately, this may create additional risk around operating underperformance.

Chart 1

Several mechanisms under the FD will promote efficient investment and reduce scope for excessive return

Ofgem acknowledges that for RIIO-1, some of the cost allowances were set too high and some performance targets were set too low, leading to outperformance on totex and high return on regulated equity across the industry. For RIIO-2, Ofgem proposes several mechanisms with the aim of balancing the interests of consumers and investors. Under the FD, about 70% of baseline totex for GDNs and about 50% of baseline totex for TOs is linked to mechanisms such as price control deliverables, compared with about 10% for RIIO-1. Such mechanisms are designed to ensure that allowances are linked to delivery outputs, therefore reducing opportunities for achieving outperformance on totex allowances without delivering a clear customer benefit.

Furthermore, a package of uncertainty mechanisms allows companies to bring forward strategic investment during the price control period to drive the transition to net zero. Finally, for RIIO-2, Ofgem also introduced a symmetrical return adjustment mechanism to provide protection in event that networks' returns are significantly higher or lower (300 bps-400 bps) than anticipated at the time of setting the price control. We believe the lower potential for overperformance removes a degree of financial flexibility going forward but we also recognize that companies will benefit from downside protection and more predictable returns.

The FD leaves scope for CMA referrals from energy networks

While we expect that energy networks will consider the FD to be more favorable than the DD, our preliminary cost/benefit analysis implies that they might consider referring the FD to the CMA. Unlike their water counterparts, energy networks can refer specific areas of the FD to the CMA instead of getting a full re-determination, provided they are deemed material. In our view, this significantly limits the downsides of a global framework revision and potential unfavorable adjustments to future operating conditions, while providing potential upside on the points networks have identified as unfavorable. Among others, the regulator decided not to aim up certain parameters of the cost of capital (including the cost of equity), despite what the CMA indicated in its preliminary conclusions for the water sector. This may therefore provide some ground for energy networks to consider the relatively high risk borne by energy network investors compared with their water counterparts, given the challenges associated with the energy transition over the coming decades.

Energy networks are due to submit any applications for permission to appeal to the CMA around early March 2021. We expect them to wait for the publication of the final conclusion from the CMA on water companies' appeals, due to be published in the middle of February 2021, before deciding whether to appeal to the CMA. Unlike the water companies' latest price review FD referrals--for which the CMA could use a six-month extension on top of the original six-month window to provide its conclusion--the CMA only has a one-month extension option available for RIIO-2 FD potential referrals, after the initial six-month window. Findings on any appeal on RIIO-2 FD should therefore be known by October 2021 at the latest.

Resilience In The Face Of COVID-19

We continue to see U.K. utility companies as relatively resilient to the effects of the COVID-19 pandemic, given the essential service they provide and the regulated or long-term contracted nature of their activities.

Shift in consumption patterns

Remote working has become more prevalent worldwide, resulting in increased household energy consumption, while non-household (industrial and business) consumption has predictably suffered. Between March and May this year, power demand was about 15%-20% lower than the initial forecast by the electricity system operator National Grid. Since then, demand recovered but stayed slightly below pre-pandemic expected levels. At the same time, extreme weather conditions and a slight increase in operational costs against a decrease in capex will dominate water companies' results this year. Overall, we forecast a 5% decrease in industry average EBITDA for the financial year ending March 2021 compared with pre-pandemic expectations. The impact on companies with exposure to unregulated and overseas operations is likely to be more significant.

Water companies and networks will recover missing 2020 revenues over 2022-2023

The regulatory frameworks for the water and energy sectors include mechanisms that enable companies to compare actual revenue in any specific year with the amount allowed under the FD. Any over/under recovery is reversed in the subsequent year, so the company's overall position is neutral compared with the FD. There is a two-year lag between any over/under-collection and the subsequent true-up, so any under-collection in 2020/2021 should be offset by an increase in allowed revenue in 2022/2023. At the same time, we note that water companies and energy networks could struggle to meet operational targets this year given disruptions to their operation and extreme weather conditions and, as a result, they could be subject to penalties. It remains to be seen if the regulators acknowledge the unique circumstances companies have faced as a result of the pandemic and relax the targets for the year.

The risk of lower inflation

We believe that prolonged low inflation may slightly erode credit metrics. While not part of our base-case scenario, we expect that if the pandemic combined with subdued economic fundamentals caused persistently low inflation, it could weigh on U.K. utilities. This is because U.K. regulated utilities' revenues and asset bases are adjusted for inflation, albeit with a two-year lag. Therefore, a period of low inflation could suppress growth in the asset base and revenues. We note that U.K. regulated utilities are partially hedged against such risk because they maintain exposure to index-linked financing (about 30%-50% of debt in indexed linked form).

Chart 2

Suppliers could see more unpaid bills

The weak macroeconomic conditions on the back of the coronavirus outbreak could see companies experiencing a surge in bad debt provision, while working capital requirements could also increase. However, so far there is limited evidence for such a surge. We believe that government support and particularly the introduction of the furlough scheme--now extended until March 2021--provides some relief to individuals and businesses, significantly easing the economic impact of the pandemic. We view this as one of the main reasons for water and energy retailers' robust collections so far this year. However, next year's collections are more uncertain once the government withdraws the furlough scheme.

No Immediate Brexit Implications

The U.K. ceased to be a member of the EU at the end of 2019. Discussions on the future relationship between the two sides once the transition period ends at the end of the month are ongoing. Whether the two sides can reach an agreement and whether such agreement would pass through parliament is uncertain. If they fail to reach a deal, future trade will be based on general World Trade Organization rules. We generally do not expect the immediate implications of Brexit to be material for the stand-alone credit quality of rated U.K. utilities. This is because their business operations largely take place in the U.K., with limited cross-border transactions and the fact that several utilities benefit from local monopoly positions and supportive regulations. Furthermore, U.K. utilities have a good track record of accessing financial markets even during financial crises and periods of high volatility.

That said, the key risk is around supply chain resiliency. More specifically, short-term operational disruptions as a result of a delay in the flow of goods into the U.K. To address this risk, we understand that U.K. utilities collaborated and have implemented detailed contingency plans to minimize the risk including increasing stock for key materials and chemicals.

The U.K.'s future environment and climate change policy and how closely aligned this will remain with EU standards is unclear. This could lead to pressure on U.K. utilities' operating expenditure as a result of changes in the U.K. government's environmental policies, which could increase the costs of utilities fulfilling their environmental obligations. Finally, U.K. utility companies could face difficulties in attracting and hiring skilled and unskilled employees, which could push up wages. In our view, these factors could reduce the credit quality of U.K. utilities in the long term.

Ongoing Risk For U.K. Water Utilities

Ofwat's FD is credit negative

Following the publication of Ofwat's final determination in December 2019, S&P Global Ratings downgraded five U.K. water companies. We also put the ratings on two out of the three rated companies appealing to the CMA on CreditWatch with negative implications while revising the outlook on the third to negative (see "Four U.K.-Based Water Utilities Downgraded On Tougher Regulations; Two Put On Watch Negative; Four Outlooks Negative," published Feb. 25, 2020, on RatingsDirect).

These actions reflect our view that the FD would pressure the credit quality of U.K. water utilities in the next price control period beginning on April 1, 2020 (AMP7; covering 2020-2025)). When the U.K. water utility regulator Ofwat published its FD for water companies in England and Wales in December, after completing its price review (PR)19, it reiterated its chief goal of providing customers with better service at lower costs, while focusing on operational performance and the environment. Water companies will therefore earn lower returns in AMP7 while being required to maintain high efficiency and meet demanding regulatory targets on leakage reduction, decreased service interruption, and improved customer service (see "Ofwat's Final Determination Leaves U.K. Water Companies’ Credit Quality Under Duress," published Dec. 17, 2019).

CMA appeals may not be enough to maintain ratings

Following the FD, all the companies regulated by Ofwat could appeal the outcome to the CMA, which a record four companies decided to do. Following the appeal, the four companies submitted their representations to the CMA, to which the CMA published its preliminary findings in September 2020.

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 weighted-average cost of capital from those used by Ofwat (see table 3). 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 AMP7 to deliver its business plan. 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.

Table 3

Overall, we consider the CMA's preliminary findings as generally credit positive for the three rated companies that appealed Ofwat's FD. That said, we remain aware that these findings are still provisional, and we note the strong criticism the preliminary finding attracted, particularly from Ofwat.

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 plans to send its conclusions to Ofwat by mid-February 2021. 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 better placed 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 they 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.

Related Research

• Industry Top Trends 2021 EMEA Utilities, Dec. 10, 2020
• The U.K. Telecoms Market Will Pick Up In 2021-2022 As Pandemic Headwinds Ease And Fiber Investments Accelerate, Dec. 10, 2020
• Energy Transition | How Far Off Is The Hydrogen Economy?, Dec. 3, 2020
• How Hydrogen Can Fuel The Energy Transition, Nov. 19, 2020
• Clean Hydrogen Investment Is Still A Leap Of Faith For European Utilities, Nov. 16, 2020
• U.K. Water Utilities: Was Appealing Ofwat's Determination Worth It?, Oct. 1, 2020
• The Energy Transition And What It Means For European Power Prices And Producers: Midyear 2020 Update, June 8, 2020
• 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, May 16 ,2018