Ofwat's 'Water 2020' plans credit negative for UK water sector, Moody's says

Following a request by the government, Ofwat has to provide an assessment by May on the costs and benefits of extending retail competition to household customers in England while competition for non-household customers will be introduced from 1 April 2017.

Furthermore, Ofwat proposes to replace Retail Prices Index (RPI) inflation with the lower Consumer Prices Index (CPI) measure of inflation as the benchmark for tariff increases and to use an average of the two indices for regulatory capital value (RCV) growth from 2020.

In a note to clients, Moody's noted that if implemented retail competition could increase cashflow volatility and, where revenue losses cannot be offset by cost savings, pressure earnings; and potentially increase counterparty risk exposure towards small and less well-capitalised new entrants.

The regulator's proposals come at a time of heightened political scrutiny. In December 2015, the UK government announced plans to extend retail competition to household customers, subject to an assessment to be carried out by Ofwat.

Separately, a report by the House of Commons Public Accounts Committee (PAC), published on 13 January , concluded that Ofwat had consistently overestimated water companies' financing and tax costs when setting price limits and called for the regulator 'to secure a better deal for customers'.

Moody’s said while the proposed changes are credit negative for the sector overall, companies' individual exposure varies. Reforms relating to sludge treatment and disposal, for example, will only affect the larger companies, while the smaller water-only companies are more exposed to the move towards CPI indexation of revenues and RCV, or a new approach to setting the cost of debt allowance.

They also have most to lose from the introduction of retail competition. Moody’s also noted that proposals to set tariffs for sludge under a separate price control, and on the basis of a price rather than a revenue cap, from 2020 will expose sewerage companies to volume risk.

“There is also potential for full competition from 2025 a further credit negative. While any expenditure added to the RCV through 2020 will be 'protected', this may not be the case for all subsequent maintenance investments for those assets and - in the long run - companies will be exposed to the risk of asset stranding,” said Stefanie Voelz, Vice President and Senior Analyst at Moody's.

"Individually, the proposals would be unlikely to have a significant negative impact over the medium term. However, we believe that, taken together, the proposed changes would decrease the stability and predictability of cash flows for the water and sewerage companies over the medium to long-term, which will be credit negative.”