Water companies will overspend and struggle to meet efficiency targets set by Ofwat, according to ratings agency Moodys.
The company has also warned about the potential for a protracted investigation by the Competition and Markets Authority (CMA), which has already said it may extend its deadline to resolve appeals beyond the normal six months.
In a note published today (10 December) Moodys set out a timetable for hypothetical CMA appeals. Companies have until 15 February to appeal to the CMA but the final determinations would apply until March 2021 regardless of the outcome of any appeal.
The agency also cautions that the determinations are predicted to trigger the greatest damage to the water industry’s credit rating for 30 years, with Moodys holding a negative outlook on 12 of the 15 rated companies.
It predicted companies would opt to defer spending during the next investment period to meet Ofwat’s cost allowance targets – which was £1.9 billion lower than companies said they needed to spend at draft determinations.
The credit rating company highlighted that Ofwat has not softened its position throughout the process and even reduced its estimation of efficiency costs by £2 million prior to the draft determinations despite companies reducing their planned expenditure by £1.4 billion.
Moodys believed the regulator will make some concessions relating to “disproportionately large” penalties because outcome delivery incentives (ODIs) have increased for most companies during the process as the regulator has tightened targets, increased penalties and removed caps.
This discrepancy led to companies stating their business plans could not be achieved in line with Ofwat’s cost targets and many called the draft determinations “unfinanceable”.
Moodys said of the gap in totex difference: “We believe that most of the gap is the result of efficiency targets that most companies will struggle to reach, and that the industry as a whole is likely to materially overspend cost allowances if they are not increased at final determinations.”
Some of the overspend could be recovered in 2025 but would result in higher gearing and weaker cash flow in the next period.
Moodys expects the difference between unfunded spending requested by companies and what Ofwat will allow to have narrowed but will remain significant.
“In addition, we estimate that companies would incur £1.4 billion of ODI penalties for underperformance if they achieved leakage, sewer flooding and other operational measures in line with their business plans. Most of these penalties would affect revenue during the AMP7 period, although penalties incurred in 2023-24 and 2024-25 would hit the following period because they are paid with a two-year lag.”
Companies hit hard by the penalties will feel the pressure in April 2022 as the penalties from the start of the period will have to be paid.
It said allowed returns are likely to be cut again in the final determinations despite many companies stating the draft determinations are not affordable.
Moodys expects companies will focus their efforts on activities that contribute most to ODI performance. “They may try to reduce or defer spending, although tough operational incentives will make it difficult to reduce investment significantly without incurring financial penalties and risking reputational damage.”