THE FALLOUT from the coronavirus, including delayed customer payments, increased bad debts and modified consumption volumes, will temporarily reduce cash flow, liquidity and covenant headroom of UK water companies in FY21, new analysis by Fitch Ratings says.
The credit-rating agency states that short-term cash-flow pressure will further erode rating headroom, which is already limited for companies with “Negative Outlooks”, including Southern Water, Yorkshire Water, Osprey Acquisitions (Anglian Water’s holding company), and Kemble Water (Thames Water’s holding company).
A longer-lasting or more severe reduction in revenue than in the company’s base case assumptions would increase pressure on ratings across the sector.
Fitch Ratings expects working capital to be adversely affected by delayed household (HH) and non-household (NHH) customer payments.
The NHH segment is currently facing more challenges as the recent regulatory code changes allow NHH retail suppliers to defer up to 50% of the wholesale charge for bills payable from March to May 2020.
Fitch Ratings states that they expect most of these amounts to be recoverable in the long term, but the settlement mechanism has not been developed, pending a consultation paper from Ofwat.
The regulator has stated its willingness to limit wholesalers’ exposure to “unreasonable financial risk”, but at the same time stressed the need for ‘pain sharing’ between retailers and wholesalers.
NHH customers’ contribution to water companies’ revenue varies between 20% and 30%, so the code change creates a maximum exposure of about 2.5%-3.8% of annual revenue. If the code change is extended to support the business retail market further, the water companies’ exposure could increase significantly.
The coronavirus has caused a shift in water consumption between customer groups, including a sharp drop in NHH consumption volumes, which will be partially offset by the increase in HH consumption.
However, this could ultimately lead to lower revenue in FY21 than allowed by the regulator. This revenue shortfall is recoverable with a two-year lag via a revenue correction mechanism.
We expect the water sector to cope with the short-term cash-flow pressures reasonably well.
Most of the companies have sufficient liquidity to cover their needs in the next 12-18 months.
Additionally, the sector can re-profile its total expenditure as some of non-essential projects can be delayed due to the lockdown.
However, the already low covenant headroom caused by the 2019 price review (PR19) could shrink further in FY21 and would need to be managed.
This is particularly relevant for interest cover covenants.
If the companies are not able to recover revenue in the medium term, their ratings could come under further pressure.
For example, a significant increase in HH bad debts or a transfer of some excess credit loss from NHH retailers to wholesalers could be credit-negative.
Fitch modelled the companies’ base-case exposure (which assumes 50% of three-month NHH revenue is not recovered immediately) to the NHH sector as a percentage of regulatory capital value (RCV).
It varies between 0.3% and 0.6% of RCV, which is manageable for the companies with solidly positioned ratings, such as United Utilities, Wessex Water, Anglian Water, Affinity Water and DWR Cymru.
However, under a more prolonged and severe stress the exposure could double or triple, potentially resulting in outlook changes or rating downgrades.
The water companies’ financial profiles could be affected by missed performance targets, leading to higher outcome delivery incentive (ODI) penalties.
The companies may be unable to read customer meters and could miss per capita consumption or other performance targets due to the lockdown restrictions.
Ofwat has indicated that it would consider ex-ante adjustments during the next round of the performance reconciliation process, but it appears that the onus will be on the water companies to show how their operations were affected by the coronavirus.
In Fitch Ratings’ base case financial modelling, the company currently assumes that the NHH revenue is recoverable from customers in FY24-FY28, which has a modest impact on the ratios in AMP7.
The company does not assume any additional coronavirus-related ODI penalties.
They will be updating their assumptions once more information on the coronavirus crisis duration and regulatory response emerges.
