UK water faces ‘lower returns and higher volatility’

Regulatory changes could hit utility companies’ cashflows and heighten downside risk, says S&P.

A golden age for UK water utilities faces jeopardy as the industry approaches the turn of the decade, according to Standard & Poor’s.

In a report released today, the agency details regulatory changes currently being considered by Ofwat, the UK regulator, for the five-year period starting 1 April 2020.

S&P believes the authority has “clearly signalled a steer towards affordable tariffs for customers”, where allowed returns on equity could be reduced to between 3.5 percent and 4.5 percent from today’s 5.65 percent. Ofgem is also proposing to link the cost of new debt taken on by companies to an index, exposing it to potential rises in interest rates.

While S&P does not dispute the rationale for such measures, it does point out that they will make cashflows more volatile, possibly weakening a major attraction to the sector from an investor’s point of view.

The regulator is proposing to introduce new incentives that would provide partial compensation for the cut in returns, broadening the range of metrics on which they can achieve overperformance. But it has also indicated that it will stiffen penalties – and make them potentially unlimited – to punish “inefficient operators”.

Thames Water – a large stake in which recently transited from Macquarie Infrastructure and Real Assets to Borealis and Wren House for more than £1.3 billion ($1.7 billion; €1.5 billion) – was fined a record £20 million in March for a huge leakage in the river Thames.

“The increased scope for earnings from incentives will provide partial compensation, but such earnings and penalties are difficult to forecast and less stable. Relative operational performance would therefore become even more important,” S&P said, noting that the review would likely reduce “rating headroom” but cause few downgrades.

“Our view of Ofwat's low-risk, credit-supportive regulatory framework is […] dependent on the maintenance of the financial attractiveness of the sector to investors,” the agency concluded.