Plans by Ofgem and Ofwat to drastically reduce the baseline returns of regulated utilities within upcoming price controls pose a significant threat to their credit ratings, which could fall to below investment grade, Moody’s has warned in a new report.
The ratings agency says the regulators’ approach to financing has hardened over time and they now seem willing to accept to lower ratings as “the price to pay for ensuring lower customer bills and greater legitimacy.”
“The regulators have a statutory duty to ensure efficient companies can finance their functions, but that does not mean that allowed returns will continue to support strong investment-grade ratings”, it explains.
“Regulators have now largely put the onus on companies to address pressure on credit metrics, and highly leveraged companies with expensive long-dated debt may struggle to do so.”
The report notes that although regulators have long emphasised that it is up to companies to decide how to structure their finances in terms of the split between debt and equity, the cost of diverging from their notional ideal of an efficiently financed company has increased sharply.
“Regulators therefore appear to be willing to accept ratings for actual companies that are less resilient to variations in actual financing costs and operational performance than in the past,” it adds.
It points out that few regulated utilities adhere to this ideal, with many having much higher levels of debt as a proportion of their regulatory asset value.
Debt levels and costs for water companies and energy networks
Moody’s says this pressure is most acute in the water sector, where the agency has assessed 80 per cent of water to companies to be at elevated risk of a downgrade. It says there is a “clear risk” that the sector average could fall from Baa1 to Baa2.
Many of their lending agreements include covenants that limit pay-outs to shareholders if certain thresholds are met, for example, if their levels of debt rise too high.
The report says these commitments are generally beneficial to their credit ratings but adds that “the devil is in the detail”. If a covenant to applies to an operating company with a holding company above it, then it could reduce the dividends that the holding company uses to service its own debts.