Upstream reform could muddy UK waters

Posted: Wednesday 28th October 2015

According to Moody's Investors Service, reform of the UK water sectors' upstream activities, including water resourcing and sludge treatment and disposal, is becoming ever more likely. The impact on credit quality of changes being considered by the Water Services Regulation Authority (Ofwat), the economic regulator for the water companies in England and Wales, would depend on their scope, but the introduction of meaningful competition would likely be credit negative for the incumbent water companies.

Moody's report titled "UK Water Sector: Upstream Reform Could Muddy UK Waters" is now available on

"The water sector is facing challenges including changing weather patterns and population growth in already water stressed areas, and will need to evolve to ensure sustainable provision of services into the future. We expect regulation to adapt to changing circumstances and reform could lead to little change in the credit quality of the water companies, but competition could also result in a significant deterioration - even if we consider this less likely", said Stefanie Voelz, Moody's Vice President and Senior Analyst.

Opening the water sector to competition brings unique challenges. Water is not like gas and electricity; its physical characteristics and geographical constraints mean that moving water over long distances can be very costly. In addition, the way the sector is remunerated today, with an allowed return set by Ofwat on a regulated asset base that carries a very significant discount against the replacement cost of the assets, makes achieving a balance between attractiveness for new entrants and viability of existing operations complex.

The regulator is currently focused on encouraging increased water trading and allowing new entrants to provide water resources as well as sludge treatment and disposal services. To illustrate how the sector may change Moody's consider three hypothetical future scenarios, with incumbent operators facing varying degrees of competition, including two scenarios with elements that go beyond current regulatory thinking.

Moody's would consider the following factors when assessing the credit impact of increased competition under these scenarios: (1) changes to the business mix, such as the extent to which the incumbent relies on activities that are opened to competition; (2) potential changes to remuneration for investments and how this might affect overall profitability; and (3) the potential for stranded assets.

Companies' exposure to reform varies. Companies that have a greater proportion of assets or costs tied to the activities facing competition could be more at risk. Highly leveraged water companies remain most exposed to reform within the sector owing to their lower financial flexibility. While business and financial risk implications of upstream reform could be small depending on the scenario, existing financing arrangement might constrain reform.

Water companies' financing structures include features thatare designed to protect creditors from significant changes to the industry structure. To implement upstream reform while maintaining the sector's historic access to low-cost and long-term funding, it will be important that all parties, including investors, are engaged within the debate and understand the rationale for any changes. Investors may decide whether or not to support reform depending on their understanding of the ultimate outcome as well as their appetite for the resulting risk profile in the context of available returns.

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