Ofwat's DPC model aims to achieve cost savings and improve project delivery, while attracting new private capital to the sector. The new framework applies to projects with total lifetime expenditure of at least £200 million. Ofwat will also consider using the DPC model for large projects below this threshold, if it could offer value for money.

Under the DPC model, water companies put relevant projects out to competitive tender. A competitively appointed provider (CAP) is then engaged to design, build, finance, operate, and maintain the relevant infrastructure (see chart 1). The DPC model aims to achieve efficiency, transparency, accountability, and value for money for customers.

Chart 1

In this article, S&P Global Ratings assesses the implications of the DPC framework for its ratings on English and Welsh water utilities. We also describe the approach we expect to take to rating DPC projects.

Key Implications For Utilities

The framework should mean that the sponsors, contractors, and consumers of a large capital expenditure (capex) project would assume responsibility for a significant amount of the associated project risk, rather than the utility retaining it all.

We may exclude the project's debt from the utility's adjusted debt, to the extent that we consider the utility to have adequate protection from contractual and regulatory risk-transfer mechanisms, and when we view contingent risks as remote and limited. When such protection is insufficient, we view contingent risks as more likely to materialize on the utility's balance sheet, or the residual value is significant, we would include the related liability in our calculation of the utility's adjusted debt.

So far, five publicly rated U.K. water companies have DPC proposals with published DPC frameworks, but Ofwat has yet to approve any (see table 1).

Table 1

Key Implications For Project Finance Companies

We could rate DPC projects under our project finance methodology if the key relevant attributes are present, including the covenant package, access to available security interests, and bankruptcy remoteness.

We anticipate that the main risks for DPC projects are likely to arise during construction--once completed, we expect operational risk to be low thanks to the predictability of the regulated revenue stream. The construction phase credit profile will depend on the project's complexity, and on the degree of risk mitigation through contractual risk transfer to contractors and consumers, especially if the risk of cost overruns is significant.

If the project does not have sufficient funding to cover not only its baseline capex, but also the cost overruns we consider in our likely downside scenario, this would greatly impair the project rating. When calculating debt service coverage ratios (DSCRs) during the operations phase, we assume that the opening debt position will include any cost overruns that the project may absorb under a downside scenario.

Counterparty exposure will most likely constrain the DPC project ratings, depending on the rating on the respective utility and taking into account our expectation of the utility's business continuity. This is because the utility is a material and irreplaceable counterparty that collects the project's regulated revenue. We could further differentiate the project rating from the utility rating if we had greater certainty from the regulator or administrator that the utility would not stop operating payments or change the DPC contract if it defaults. We also understand that the utility's obligations toward the DPC project could be underpinned by the license conditions.

Potential For Improved Efficiency In The Utility Sector

The framework provided by the DPC model has not previously been used in the water sector. It has the potential to yield cost savings and improve project delivery and quality, customer satisfaction, as well as transparency, accountability, and sustainability. The hope is that these benefits will arise through the competitive tendering process under which CAPs specializing in project delivery would drive innovation. These CAPs could have specific expertise in areas outside a utility's regular investment programs. For example, they could be tunnelling or reservoir specialists.

For some utilities, DPC projects can be larger than their regular capex projects. They can also be complex, which poses its own set of risks. At the same time, the DPC model itself carries certain risks.

Initially, we can see the need for additional resources to procure a CAP and negotiate a contract. Although the CAP would take on some risks, the utility could be exposed to higher contractor performance risk if it outsources work, rather than completing capex programs in the usual way.

Value for money is one of Ofwat's key considerations before it permits a utility to put a potential DPC out to tender. If Ofwat believes that there is more value for money in the utility making an investment themselves, it will not allow the project to go to tender. To assess the value for money of a DPC project versus in-house completion, Ofwat has set out clear assessment guidelines for utilities to follow to enable them to compare and contrast the risks and benefits of one over the other.

Overall, while the DPC model offers opportunities for cost savings and efficiency improvements, it requires efficient planning and careful risk management to demarcate and mitigate risks. As contracts are likely to be uniquely tailored, a lot will boil down to the way that the utility and the CAP allocate contractual obligations--for instance, in terms of risk-sharing and early termination--and to potential regulatory intervention if things don't go according to plan.

Utilities Would Largely Be Shielded From Project Costs And Capex, In Most Instances

In most instances, project costs should not have any bearing on a utility's financials, except for contingent risks and the payment of the residual asset value at the end of the DPC concession.

In general, the CAP will bear the design and construction risks, making the appropriate commercial arrangements with contractors. The CAP will also charge the utility a fee to recover any DPC-related costs. The utility will pass these fees on to consumers. The utility will recognize the corresponding customer contributions separately from its own regulated revenue and will offset the fees that it pays to the CAP.

Consequently, we do not expect any impact on the utility's earnings during the construction phase. Post construction, once the project is completed, customer bills will start to reflect the cost of the DPC project over the DPC concession period for a pre-determined length of time that will vary from project to project.

We anticipate that the number of years that the fees will affect customer bills will be set in the CAP agreement; this will likely depend on the overall cost of the project and on considerations of intergenerational fairness. We don't rule out the possibility of cost recovery via consumer bills during some projects' construction phase if the regulator deems it a better value proposition. At the end of the DPC concession, the project will transfer the asset to the utility upon the payment of a residual amount. Only from this point will the utility include the asset in its regulated capital value.

However, contingent risks persist. Risk-sharing between the CAP and utility will be project-specific. If the pre-defined construction cost overrun thresholds are exceeded, the utility will pass construction cost overruns on to consumers, although the extent could differ from project to project.

The impact of construction issues on the utility will vary from project to project and depend on the reason for project failure. That said, we expect the utility's exposure to project risks in the construction phase to be limited in a typical scenario where there are no operating issues or material cost overruns that the utility cannot recover through regulatory mechanisms.

Operational Repercussions Could Prompt A Utility To Extend Financial Support

In some instances, the project may be crucial to the utility, and walking away from an incomplete project may have profound operational repercussions for the utility, even if the immediate financial implications are relatively limited. In such an instance, the utility could either re-tender the project to another CAP, or complete it by itself, financing it through the normal price control framework.

However, if the utility does choose to provide financial support to the CAP, it is likely to be able to recover this support via the price control period, subject to Ofwat's approval. The utility itself would likely have to absorb any residual costs that the regulator did not deem recoverable. This could occur if the utility considers that the benefits of completing the project outweigh the costs. Absorbing these costs could impinge on the utility's creditworthiness, depending on the magnitude of the overrun.

Protracted delays to the project's construction--or even operational issues with the completed project following transfer to the utility--could have implications for the utility's operational performance and, in turn, attract penalties during the regular price control periods. The completed project could also have its own operational issues and not deliver the improvements originally envisioned. The degree to which this would affect our rating on the utility--if at all--would depend on the magnitude of the problem, the ensuing financial burden that the utility would have to bear, and any mitigating actions it could implement.

The Treatment Of Project Debt Within The Utility's Adjusted Debt

If we view the risk of the utility bearing cost overruns and project failure as remote and limited, we may exclude the project debt from the utility's adjusted debt. Normally, although the debt will be issued by the CAP, rather than the utility, the present value of the project's future cash flows under the DPC framework will show on both sides of the utility's balance sheet, both as a fixed asset and as a liability. However, the utility won't acquire the asset from the CAP until project termination, and its value will not be part of its regulated asset base. From a regulatory perspective, both the asset and the utility's liability to pay to the project will be ignored during the construction and operation phases. Eventually, at the end of the concession, the utility will acquire the asset. The residual value will depend on the relative life of the asset, compared to the length of the CAP agreement. However, we believe that, in many cases, residual value is likely to be modest because the project will be deeply amortized. If this is not the case, we could consider consolidating with the utility's adjusted debt.

In most cases, we would consider the project's debt as a contingent liability for the utility. We would include such a liability in the utility's adjusted debt when we see a meaningful probability that the liability could crystallize on the utility's balance sheet, with low prospects of recovery via regulated price control mechanisms. That said, consumers or counterparties could bear a large part of the burden for potential cost overruns, and even for project failure, via contractual stipulations on risk sharing. The onus will not necessarily fall on the utility alone. In such cases, we may exclude the project debt from the utility's S&P Global Ratings-adjusted debt.

A relevant example that predates the DPC framework is the Thames Tideway Tunnel, which we do not consolidate into the adjusted debt of the regulated operating company, Thames Water Utilities Ltd. The project involves the construction of a new sewer to supplement London's existing sewage network, at a cost of £4.5 billion. Private investors are responsible for the design, financing, building, and maintenance of the tunnel by way of a separately owned and regulated company with its own license. Moreover, the U.K. government has a support package in place to protect this company under certain circumstances. As a result, we do not believe that the construction and operation of the tunnel affects Thames Water Utilities' financial risk profile.

Using Our Project Finance Methodology To Rate DPC Projects

Because Ofwat's guidelines contain the specific structural attributes required under our criteria, we expect to be able to rate DPC projects under our project finance methodology. Although specific projects may choose to deviate from the Ofwat guidelines, the standard DPC framework includes:

• A limited purpose entity: A CAP is appointed to design, build, finance, operate, and maintain the relevant infrastructure;
• A closed portfolio: The project is designed for infrastructure with a specific purpose, and any changes will be subject to the license conditions and approval by Ofwat;
• A determinable economic life: The CAP's designation will remain active until the concession period ends (possibly after more than 25 years), even if the asset life may be longer; and
• A change of control: The CAP agreement should include provisions that require the appointee's prior approval of any change of ownership or control at the CAP.

Ofwat's guidance does not prescribe a predetermined set of covenants, and we believe that the covenant arrangement will depend on the stakeholders' negotiated agreement.

In addition to the features in Ofwat's DPC guidance, to qualify as a project financing, a set of minimum structural features to both limit the issuer's actions and define the creditors' rights should be present. These include:

• The bankruptcy remoteness of the issuing vehicle;
• The senior security interest over the project's assets and cash flows, to the extent permissible;
• No, or limited, recourse to the project's sponsors or shareholders;
• A cash management structure defining the priority of payments (the cash waterfall); and
• Covenants that ensure that third parties' future actions will not disadvantage creditors.

We understand that, given the nature of the water sector, license conditions, and the fact that the utility will most likely own the land, it may be virtually impossible to arrange security over the DPC projects' physical assets, such as pipelines and tunnels. Nevertheless, the security arrangements will depend on the specific nature of the project. In most cases, we anticipate that security over the project's cash flows (or some of its assets or equipment) could still be arranged. Absent key structural or security features, we would likely analyze DPC projects under our corporate methodology or other applicable criteria.

Funding Sufficiency, Risk Allocation, And Counterparty Risk Will Likely Drive DPC Projects' Credit Quality

We expect the following issues to be the most relevant for DPC projects' credit quality:

• The sufficiency of funding during the construction phase, including coverage for likely cost overruns and delays;
• Construction complexity and project-specific features;
• Risk allocation during construction (that is, which risks the project retains and which it shares with the utility and construction subcontractors or passes through to the utility's customers);
• Exposure to the utility as a counterparty during both the construction and operations phases; and
• Any support offered by the utility and the nature of the specific project's termination mechanisms.

A DPC-Specific Risk-Allocation Mechanism May Help Address Potential Construction Complexities

In our view, the main risks for DPC projects are likely to arise during construction. Once the asset is constructed, we expect stable and predictable revenue to support the operations phase credit profile.

The DPC framework has been designed to support large and complex projects. In our view, such projects could be more exposed to technical issues, delays in completion, and cost overruns than is typical for the water sector. Under our sector-specific project finance criteria, during the construction phase we typically assess water pipelines as a simple building task (measured on a scale from 1 to 5, where 1 represents the lowest risk, this would be assessed as a 1). We typically assess more complex water pipelines in challenging terrain as moderately complex buildings or simple civil works (2), and we could assess tunnels as civil or heavy engineering works (3).

The rising cost of civil construction in the U.K., inflation, and the supply-chain issues we have often seen in recent years could also exacerbate the risk of cost overruns for DPC projects. Ofwat's guidance stipulates that the DPC project, its subcontractors, the utility, and the end-customers will share underspending and overspending of capital costs, with contracts determining the specific proportions. Although turnkey contracts typically offer the strongest form of risk transfer, we believe that in the current macroeconomic environment, it would be challenging for any project, not only a DPC project, to secure a fixed-price turnkey contract for large long-term construction works.

That said, we understand that at least some DPC projects will be able to shift quite significant amounts of cost variations to contractors or consumers, and view this as credit supportive. Considering this, we will focus on how much risk the project retains and whether there are any incentives for the various subcontractors to deliver on time and on budget.

Finally, because the project's credit quality depends on how it manages the timing gaps between the target construction completion date and the initial debt service payments, assessing such timing gaps and mitigants is a critical part of our credit analysis.

Funding Sufficiency Can Significantly Affect A Project's Credit Quality

Our downside scenario focuses on whether a project's sources of funding (both certain and likely) will be sufficient to cover the full cost of construction, including potential cost overruns. The DPC model is likely to be used with relatively large, long-term projects. In such cases, it might be difficult for projects to secure the full amount of financing upfront; similarly, where there is insufficient transfer of the risk of cost overruns to contractors or consumers, financing may not cover cost overruns. This could constrain the ratings on the projects. If the funding gap is significant, it could prevent the ratings from reaching investment grade.

We classify funding as "certain" when it is committed upfront. We may also factor in funding with minimal conditionality, or funding from project cash flows during the construction phase. DPC projects that expect stable availability-based revenue while in operation may look attractive to investors. However, we view additional debt issuance during the construction period as being highly uncertain, especially issuance that is needed to cover project cost overruns or delays.

As per Ofwat's guidance, standard DPC projects are unlikely to generate revenue during construction. That said, we anticipate that the regulator may allow unusually large and long-term projects some flexibility in the standard scheme if it agrees that a revenue stream during construction could offer value for money. In that case, we may include such revenue as a project's funding source.

A DPC Project's Senior Debtholders May Be Protected From A Utility Default

If a project is terminated early due to a CAP default, utility default, or force majeure, the amount payable to the CAP is likely to be the same as the pre-defined amount in the CAP agreement. The reason for termination will determine whether the CAP's lenders will be fully compensated. Generally, if the CAP has defaulted, a project's senior debtholders are less likely to receive full payment and we would expect the amount recovered to be subject to a haircut. If there is another reason for termination--including a utility default, other than a cross default--the amounts due to senior debtholders and under hedging agreements are likely to be paid in full as these creditors will be protected.

Holders of subordinated debt may also recover some of the amount due to them, although we view recovery of the equity portion as less certain. Some movable assets used for construction could be pledged against the CAP's debt, but strategic assets--such as land that the utility owns or the asset under construction--will not be available to be pledged.

The Utility Counterparty Rating Constrains The DPC Project's Creditworthiness

Since a DPC project is designed to meet the needs of a specific water utility, and since the project will receive revenue from the utility, which, in turn, will be paid by consumers, we would likely consider the utility as a material, irreplaceable counterparty.

Even if technically, DPC projects are separate from their respective utilities, we would likely constrain the DPC project's stand-alone credit profile (SACP) at the level of the water utility's creditworthiness. We could raise the constraint by one notch if we expect the utility to remain in business following its potential default. Additional differentiation cannot be excluded but would depend on our in-depth analysis of a post-default scenario. In practice, this may not be relevant to the project rating; the U.K. water utilities we rate all have investment-grade ratings, as of May 9, 2024.

Ofwat's guidance indicates that a water utility company acting as an appointee will have multiple roles under the DPC model, including:

• Arranging the CAP agreement;
• Managing the CAP for efficient project delivery;
• Appointing the independent technical adviser;
• Collecting payments from customers to recover the CAP's costs; and
• Sharing the risk of cost overruns during construction (although we understand that a high proportion of these risks will fall on the CAP, its contractors, and customers).

Additionally, the DPC guidance states that the CAP agreement should not allow the CAP to terminate the agreement and replace the water utility.

Under our methodology, we could consider rating the project above the issuer credit rating on the utility if we receive sufficient confirmation of the counterparty's ability to continue uninterrupted payments to the CAP in a default scenario. Although we have not rated DPC projects yet, we understand that post-default business continuity could be a consideration. Even if a utility defaults, Ofwat or the Secretary of State could apply to the High Court for a special administration order, under the Water Industry Act 1991.

In such a case, the appointed special administration will be subject to the same statutory, license, and contractual obligations as the water company, including the CAP agreement. For the utility, the CAP agreement would then be akin to accounts payable, rather than debt, and any material changes in the CAP agreement would require Ofwat's approval.

If a utility were to enter into administration, we cannot exclude the possibility that we would increase the maximum uplift above the rating on the utility. This could occur if we had greater confidence that the utility, operating under the guidance of the regulator or administrator, was unlikely to change the DPC contract or interrupt the transfer of operating payments to the project from the amount that the utility has collected from its customers. To an extent, this may be supported by the utility's license conditions.

We would also need to consider whether or not the project's contract terms would be impaired if the utility defaulted and whether the project documentation contained unmitigated cross-defaults to the water utility.

A Stable Revenue Stream Will Underpin DPC Projects' Credit Quality During Operations

Following construction, our operations phase business assessment will largely focus on the project's ability to deliver services reliably and operate and maintain the asset while avoiding breakdowns. DPC projects are in a good position to generate relatively stable revenue streams and, by design, have low market exposure. Under our sector-specific project finance criteria, during the operations phase, we typically assess water pipelines' operational stability as 3 (on a scale of 1 to 10, with 1 being the lowest risk and 10 being the highest).

According to Ofwat's guidance, the DPC project will recover its costs (including construction, operational, maintenance, and financial costs) through the CAP charges that the water utility will pay to the DPC project. The project will have minimal exposure to market risks, such as demand or price-volatility risks. Moreover, the DPC project is likely to be able to pass through refinancing costs and inflation via future adjustments to allowed revenue, although the specific mechanisms could vary. We will therefore analyze each project's ability to pass through the cost of inflation, its exposure to floating interest rates, and any foreign-exchange risks arising from revenue adjustments or hedging, as well as examining if there are any mismatches in the timing or amount of such pass-throughs.

That said, a CAP's revenue could fluctuate because of built-in performance incentives. Thus, we will evaluate the realistic range of such fluctuations, the project's likely future performance, and any limits on risks retained by the project or built into the revenue formula.

Although market risks and cash flow volatility are likely to be low, our projected DSCR will greatly depend on the opening debt position we assume at the start of operations. This is because we factor in cost overruns under a likely downside scenario. The size of any overrun will depend on the project's complexity, the contingencies we factor into our base case, and the degree of risk transfer to contractors and customers through revenue adjustments. Even when operational cash flows are predictable and stable, this may result in lower DSCRs in our base case than in the project's.