Utilities PLC United Utilities Water Limited / United...Bkd Senior Unsecured A3 Outlook Stable...

INFRASTRUCTURE AND PROJECT FINANCE

ISSUER IN-DEPTH29 August 2019

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United Utilities PLCSenior Unsecured Baa1

Outlook Stable

United Utilities Water LimitedSenior Unsecured A3

Issuer Rating A3

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United Utilities Water Finance PLCBkd Senior Unsecured A3

Outlook Stable

Source: Moody's Investors Service

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United Utilities Water Limited / UnitedUtilities PLCOfwat sets tough targets, then makes them tougher

In January 2019, Ofwat said that the business plan submitted by United Utilities WaterLimited (UUW, A3 stable) for the 2020-25 regulatory period “set a new standard for theindustry” and awarded it fast-track status, promising to approve the plan early and with onlyminor changes. However, the draft determination published in April 2019 included tougheroperational targets and penalties than the company had proposed, and these were tightenedfurther alongside the slow-track determinations in July 2019. Because UUW has asked for anumber of amendments to its draft determination, its incentive package and cost allowances,as well as the allowed return, could change further at final determinations in December 2019.

» Revisions to outcome delivery incentives (ODIs) make penalties likely. Ofwatmade UUW's targets harder – in some instances probably unachievable – and significantlyincreased penalties for underperformance. If UUW performs in line with its business plan,we estimate that it will incur penalties of £170 million over the five years, compared withrewards of £21 million earned over the past four. UUW has announced plans to spend£100 million to improve performance in these areas before the start of AMP7, which couldreduce penalties.

» Ambitious cost targets, but Ofwat's interventions smaller than for peers. UUW'sbusiness plan promised to cut costs by 13%, excluding enhancement projects, twice asmuch as the industry average. Although Ofwat reduced allowances slightly and rejectedfour of the company's five special cost claims, the gap between UUW's plan and itsallowed expenditure is much smaller than other companies'.

» Elements of UUW's determination are still subject to change. UUW declined theoffer of “early certainty” in important areas, largely related to the ODIs and special costclaims, in the hope that Ofwat would make favourable changes in response to companies'representations. Because of this decision, UUW has been affected by generally negativechanges included in the slow-track draft determinations, although further changes couldbe made at final determinations.

» Low leverage and borrowing cost provide some protection against cuts to allowedreturn. The slow-track determinations in July 2019 signalled that allowed returns will fallfrom the level assumed in UUW's draft determination. UUW's low leverage and borrowingcosts mean that its interest coverage is likely to remain among the highest in the industry,but further cuts to the allowed return hinted at by the regulator would put financialmetrics under pressure.

http://www.surveygizmo.com/s3/1133212/Rate-this-research?pubid=PBC_1170738

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MOODY'S INVESTORS SERVICE INFRASTRUCTURE AND PROJECT FINANCE

Successive revisions to ODIs mean penalties are likelyOutcome delivery incentives (ODIs) are rewards and penalties that water companies will earn or incur in the 2020-25 period, AMP7, formeeting or failing to meet specified operational targets, known as performance commitments.

In UUW's original business plan submission in September 2018, the company proposed an approximately balanced set of ODIs, with ap10 value of -£410 million (2017-18 prices) and a p90 value of +£447 million across the five-year price control period, meaning thatUUW believed it had an 80% chance of achieving incentives within this range. The company acknowledged that certain targets, inparticular for internal sewer flooding, would be difficult to achieve and we estimated the company would incur a relatively modest £24million penalty across the period based on performance in line with the company's business plan.

However, Ofwat imposed a number of changes when it decided to fast-track UUW's business plan and made further changes betweenthis initial assessment and UUW's draft determination. Based on UUW's draft determination, published in April 2019, we estimatedthat performance in line with the company's business plan would yield an ODI penalty of around £150 million.

Subsequent decisions made by the regulator in the draft determinations for the slow-tracked companies in July 2019 will also impactcertain ODIs that UUW shares with other companies, in most cases increasing penalty rates slightly from UUW's draft determination.Although Ofwat has not provided detailed figures that would allow us calculate penalties precisely, from the information available weestimate that UUW's revised package of ODIs has a p10-90 range of approximately -£540 million to +£170 million (Exhibit 1). Even ifthe company performs at the levels indicated in its plan, which UUW described as “stretching” and “the most which may be achievableover five years,” we estimate they would pay a £170 million penalty over the period.

Exhibit 1

Despite submitting a balanced package of incentives in its plan, UUW's ODI range has skewed negative as the regulatory process hasprogressed

-£600 -£400 -£200 £0 £200 £400 £600

Business plan submission

Fast-track decision

Draft determination

Implication from slow-trackdraft determination

£m 2017-18 CPIH prices

Common performance commitments p10 - p90 range Additional p10 - p90 range for bespoke commitments

Sources: Business plan, fast track decision and UUW draft determination from Ofwat; slow track draft determination reflects our estimates based on Ofwat publications

The negative skew is largely the result of Ofwat imposing asymmetric “common” ODIs that are measured consistently across thewhole sector, such as for leakage and sewer flooding, and removing positively-skewed ODIs proposed by UUW. Several ODIs, such asfor improving river water quality and street works performance, were changed to non-financial, reputational incentives.

UUW has argued that, given the changes made by the regulator, the p10 - p90 incentive range at its own draft determinationwas -2.23% to +0.54% return on regulatory equity (RoRE), significantly less than Ofwat's indicative range of 1%-3% out- orunderperformance. The further changes announced in July 2019 increase this negative skew, in particular by reducing the potentialupside.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 29 August 2019 United Utilities Water Limited / United Utilities PLC: Ofwat sets tough targets, then makes them tougher


Unachievable targets set for some common ODIsThe expected underperformance is driven largely by common ODIs, as a result of the asymmetric incentive rates and the use of anindustry upper-quartile target in areas where UUW is operationally weaker than some of its peers. This means that companies willbe penalised if their actual performance on any of these measures is worse than the forecast performance of the third or fourth best-performing company on that measure.

In its draft determination, Ofwat reset UUW's performance target to the upper-quartile level for four ODIs: per capita consumption,pollution incidents, internal sewer flooding and water supply interruptions. Because UUW's current performance on these metrics fallsshort of the best performers, achieving the target will require significantly greater improvements than proposed in UUW's businessplan. For example, Ofwat has required a 20% reduction in the number of category 1-3 pollution incidents over the period, comparedwith a 7% reduction proposed in the plan (Exhibit 2).

Exhibit 2

Performance commitments for key common ODIsImprovement required by 2024-25

Business plan UUW's draft determination

Following slow-track

draft determination

Reduction in annual leakage 15% 20% 20%

Reduction in per capita consumption 3% 5% 6%

Reduction in pollution in incidents 7% 20% 20%

Reduction in internal sewer flooding incidents [1] 56% 73% 73%

Reduction in supply interruptions 50% 75% 75%

[1] Business plan performance commitment based on number of incidents, draft determination based on incidents per 10,000 connections.Source: Ofwat

At the time of the fast-tracking decision, Ofwat also decided that the penalty rates UUW proposed were “too low” and intervenedto increase penalties for underperformance by as much as 4x the company's proposed rate. UUW in turn proposed to increase itsoutperformance incentive rates, arguing that its customer research supported symmetric reward and penalty rates, but Ofwat refusedthis, saying the company had “not provided any justification” for the increase.1

In July 2019, Ofwat made further interventions where it believed that the incentive rates proposed by companies, or set out in the fast-track draft determinations, fell outside a “reasonable range” when normalised on a per-household basis. In particular, Ofwat decidedthat the penalty rate for supply interruptions, where UUW expects to underperform, should be doubled from the level it had used inUUW's draft determination.

Exhibit 3

We now expect UUW to incur operational penalties against the common ODIsBased on the company's business plan expected performance

Water qualitycompliance

Water supplyinterruptions

Leakage Per capitaconsumption

Mainsrepairs

Unplanned outage Internal sewerflooding

Pollutionincidents

Sewercollapses

Treatment workscompliance

(120)

(100)

(80)

(60)

(40)

(20)

0

20

40

£m

20

17

-18

pri

ce

s

p10 - p90 range from business plan proposal p10 - p90 range from draft determination p10 - p90 implied from slow track draft determinationImpact of UUW's estimated performance (business plan) Impact of UUW's estimated performance (draft determination) Impact of UUW's estimated performance (slow track)

Sources: Business plan and UUW draft determination from Ofwat; slow track draft determination reflects our estimates based on Ofwat publications



If these decisions are unchanged at final determinations, UUW will face much higher penalties where it fails to meet commitmentsthan rewards when it exceeds them (Exhibit 3).

UUW's largest potential penalties, and Ofwat's most significant interventions, are in the areas of internal sewer flooding, water supplyinterruptions and leakage and mains repairs. However, UUW has announced plans to spend an additional £100 million to improveperformance in these areas before the start of AMP7, which could mean lower penalties than we have calculated. The companydescribes this as reinvestment of outperformance achieved in the AMP6 period.

Internal sewer floodingUUW's largest forecast penalty is for internal sewer flooding, where sewage enters a customer's property. We estimate thatperformance in line with the company's business plan forecast would result in a penalty of £82 million (in 2017-18 prices) over AMP7,over 4x the penalty under its initial proposal.

UUW has a higher portion of combined sewers than the industry and the highest level of rainfall, which the company has cited as thereason for its underperformance. The company's business plan included a performance commitment based on the company's forecastof the industry's upper quartile of 2.2 incidents per 10,000 customers, while acknowledging that it would take 10 years to achieve thetarget and the company would therefore incur penalties in the AMP7 period. It proposed a symmetric incentive rate of £2.2 million perincident per 10,000 customers.

At draft determination, Ofwat set a more challenging performance commitment, 1.6 incidents per 10,000 customers, andasymmetrically increased the underperformance rate to £8.275 million. If the company performs in line with its business plan, it will hitthe maximum penalty cap for each of the first three years of AMP7. Without this cap, the company would have faced an additional £19million penalty (Exhibits 4-5).

Exhibit 4

UUW will have the highest rate of incidents in the industryBusiness plan commitment for regulatory year 2024-25

Exhibit 5

UUW will hit the penalty cap in the first three years of AMP7Based on company expectations of performance

0.0

0.5

1.0

1.5

2.0

2.5

Incid

en

ts p

er

10

,00

0 c

usto

me

rs

Performance level in original plan

Performance level in current plan

Upper quartile performance

Regardless of submission, all companies' performance commitment will be set at theupper quartile value, which for 2024-25 is 1.34 incidents per 10,000 customers.Sources: Companies' business plans, Ofwat, Moody's Investors Service

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

2020-21 2021-22 2022-23 2023-24 2024-25

Incid

en

ts p

er

10

,00

0 c

on

ne

ctio

ns

Maximum Penalty Penalty Zone Reward ZoneTarget Forecast

Sources: Company business plan, Ofwat, Moody's Investors Service

Ofwat's interventions for the internal sewer flooding ODI

Taking the year to March 2023 as an example, UUW's business plan assumed 3.97 internal sewer flooding incidents per 10,000 customers,1.80 above their forecast upper quartile of 2.17 incidents per 10,000 customers. Based on a proposed incentive rate of £2.2 million perincident, UUW would incur a £4.0 million penalty for that year.



Ofwat set the performance commitment at a revised upper quartile of 1.58 incidents. The incident rate was also increased by a factor of four,increasing the expected penalty for 2022-23 to £19.8 million (Exhibit 6). Even if the company performed at its p90 level (a level that thecompany believes it only has a 10% chance of achieving), it would still incur an £8.6 million penalty.

Exhibit 6

Penalties for internal sewer flooding have increased significantlyBased on regulatory year 2022-23 parameters; £millions, 2017-18 prices

-25

-20

-15

-10

-5

0

5

10

0.0 1.0 2.0 3.0 4.0 5.0 6.0

Number of incidents per 10,000 connections

Draft determinations UUW's business plan

Expected penalty under business

plan

Expected performance

p90performance

p10performance

Expected penalty under draft

determinations

Upper quartile performance


In Exhibit 6, the incentive rate for outperformance (below 1.58 incidents per 10,000 connections) is based on UUW's draft determination.In July 2019, Ofwat indicated it would increase UUW's outperformance incentive rates for internal sewer flooding. However, given expectedperformance level this will not alter the financial impact of the incentive mechanism.

Water supply interruptionsWe forecast that UUW will incur a penalty of more than £40 million in the period for water supply interruptions if the companyperforms in line with its business plan.

In the financial year ending March 2019, UUW lost an average of 9 minutes 10 seconds per property per year to interruptions, whichwas a significant improvement from the company's past performance and better than the regulator's target of 12 minutes. However,the upper-quartile performance target will reduce significantly in AMP7 to 3 minutes by the end of the period, a quarter of currentlevels. UUW believes it has already implemented the most cost-benefical solutions, which have resulted in a 70% reduction ininterruptions since 2001, and does not expect to achieve the upper quartile performance in AMP7 (Exhibit 7).

In its business plan, UUW recognised that it was performing below the upper-quartile level and proposed a performance commitment(6 minutes) and penalty rate (£0.215 million per minute) that implied a penalty of £4 million over the period.

In its draft determination, Ofwat tightened the performance commitment to 4 minutes 17 seconds at the start of the period, fallingto 3 minutes by the end and increased the underperformance incentive rate to £0.71 million per minute. We estimate that the draftdetermination would have resulted in a penalty of £22 million if the company had performed in line with its plan.

At the slow track draft determinations, Ofwat made significant further changes affecting UUW. The starting performance commitmentlevel was relaxed slightly, to 5 minutes 24 seconds, although the 3 minute end-of-period target was unchanged. However, the penaltyrate was increased much further, to around £1.4 million. Taken together, we estimate that performance in line with the business planwould result in a penalty of over £40 million.



Exhibit 7

Interruptions targets will significantly tighten in AMP7Evolution of ODI from AMP6 to AMP7

00:00

00:03

00:06

00:09

00:12

00:15

00:18

00:21

2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 2024-25

Avg

tim

e lo

st p

er

pro

pe

rty p

er

ye

ar

(hh

:mm

)

Maximum Penalty Penalty Zone Deadband Reward Zone Maximum Reward Target Outturn / Forecast


Leakage and mains repairsWe estimate UUW will incur a combined penalty of £34 million on the leakage and mains repairs ODIs if it performs in line with itsbusiness plan.

UUW submitted a business plan proposing a 15% reduction in leakage. While the plan fulfilled Ofwat's business planning guidance,the regulator noted that UUW continued to lag much of the industry on normalised measures such as leakage per property and perkilometre of mains (Exhibit 8). Ofwat therefore intervened to require a 20% reduction in annual leakage over the period. If UUW onlydelivers the 15% reduction originally planned, it will incur a £10 million penalty across the price control.

Exhibit 8

UUW performs relatively poorly on normalised leakage measures2024-25 performance commitment vs. 2017-18 actual performance

50.0

70.0

90.0

110.0

130.0

150.0

170.0

3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0

Litre

s p

er

pro

pe

rty p

er

da

y

Cubic metres per kilometre of mains per day

UUW

YRK

ANH

HDD

SWWNES

WSH

SVT

SRN

WSX

⯆ Upper quartile per length of mains

⯅U

pp

er

qu

art

ile

pe

r

pro

pe

rty

Excluding all water-only companies (WOCs) and Thames Water, which is targeting 16.5 m3/km/day and 125.69 l/property/day by 2024-25. ANH = Anglian Water, SVT = Severn TrentWater, YRK = Yorkshire Water, SRN = Southern Water, SVT = Severn Trent Water, NES = Northumbrian Water, WSH = Welsh Water, WSX = Wessex Water, SWW = South West Water,HDD = Hafren DyfrdwySources: Companies' business plans, Ofwat, Moody's Investors Service

Companies are separately incentivised to reduce the number of repairs to burst mains, as a proxy for asset health. UUW's focuson leakage reduction means that it will be carrying out more repair work on water mains than during AMP6. Due to the increasedworkload, the company forecasts it will make 125 repairs per 1,000 km of pipe, higher than the 108 repairs target, resulting in anapproximately £24 million penalty over AMP7 (tightened from 110 repairs and £21 million penalty in UUW's draft determination).



Ofwat's interventions for the leakage ODI

UUW's business plan proposed a 15% reduction in annual leakage, reducing the three-year average leakage level to 409 megalitres per day in2024-25 from 450 Ml per day in 2019-20. If the company achieved this reduction, it would earn neither a reward nor penalty.

Ofwat's intervention means that the company will have to reduce annual leakage by 20%, to a three-year average of 387 Ml per day over2022-25 to avoid penalties. Ofwat also increased the underperformance penalty rate to £0.175 million from £0.129 million. If UUW performedat its business plan's proposed level, it would incur a £3.9 million penalty in the final year of AMP7 (Exhibit 9).

Exhibit 9

UUW will have to reduce leakage by an additional 5% on top of its planned 15% reduction to avoid penaltiesBased on regulatory year 2024-25 parameters; £m 2017-18 prices

-8

-6

-4

-2

0

2

4

6

8

300 320 340 360 380 400 420 440 460

3-year average leakage (Megalitres per day)

Draft determinations UUW's business plan

No financial impact under business plan

Expected performance

(15% in annual leakage)p90

performancep10

performance

Expected penalty under draft

determinations

Draft determinations target

(20% in annual leakage)


Upside from bespoke ODIs significantly curtailed at draft determinationOfwat also asked companies to develop bespoke performance commitments to reflect their customers' preferences. UUW's businessplan included a number of bespoke incentives, the two most important being for an initiative it calls “systems thinking capability” andfor improving river water quality. Overall, the bespoke ODIs could have lead to penalties of £300 million or rewards of £385 millionover AMP7. Ofwat's draft determination for UUW reduced the range and positive skew of these incentives, with a p10/p90 range of -£216 million to +£250 million. Further interventions in July, focused on reducing complaints from customers on water quality reducedthis range to around +/-£200 million.

UUW's largest bespoke ODI was for systems thinking capability, the process of embedding machine learning and robotic processautomation to allow the company to view all its operations as a complete system rather than distinct silos. While the companybelieves such a programme would reduce costs in the long run, the benefits would not be self-financing within the five-year period.Rather than requesting a total expenditures allowance to cover these costs, UUW proposed a bespoke ODI that was calibrated to fund25% of the cost. Another 25% would be funded by shareholders, with the remaining 50% funded through the total expenditure sharingmechanism, which allows UUW to recover half of all overspending from customers.

UUW's proposal defined “capability maturity” on a scale from zero to five, with the company expecting to begin AMP7 at level one.The company would be awarded £37 million if it reached level three, £74 million if it reached level four, or would lose £37 million ifcapability regressed to level zero.

Although Ofwat said UUW “shows the most embedded innovation culture, with an ambitious and sector-leading approach toinnovation capability,” at draft determinations it intervened to remove the financial payments from this incentive, stating that UUW'starget was not stretching or innovative when compared with other companies' proposals and that the evidence the company hadsubmitted for customer support was insufficient.



Ofwat also altered several of UUW's smaller bespoke incentives, where the regulator determined that there was insufficient evidence orthere believed they could result in double remuneration across similar output categories (Exhibit 10).

Ofwat's decisions for the slow-track companies mean changes to eight of UUW's bespoke ODIs. The most significant of these is forthe number of water quality complaints due to taste, smell and appearance, where reward and penalty rates have been set at less thanone-third of the level used in UUW's draft determination. Because this ODI had more upside than downside for UUW, the changeincreases the negative skew of the company's ODI range.

Exhibit 10

Ofwat removed UUW's largest bespoke incentives in the company's draft determination£ millions 2017-18 prices

ODI

Business plan p10 to

p90 range

Draft determinations p10 to

p90 range Changes

Systems thinking capability -37 to +74 N/A Removed financial incentives, reputational only

Improving river water quality -50 to +50 N/A Removed financial incentives, reputational only

Hydraulic internal flood risk resilience -29 to +31 -44 to +46 Range expanded and incentive rate increased

Reducing water quality contacts due to taste, smell

and appearance [1]

-20 to +37 -29 to +57 Expand scope and tighten targets

Number of customers lifted out of water poverty -24 to +23 -14 to +14 Cap and collar applied to limit range

Street works performance -22 to +22 N/A Removed financial incentives, reputational only

Keeping reservoirs resilient -19 to +16 N/A Removed financial incentives, reputational only

Hydraulic external flood risk resilience -14 to +14 -21 to +21 Range expanded and incentive rate increased

Improving the water environment -4 to +8 N/A Removed financial incentives, reputational only

External flooding Incidents -1 to +2 -27 to 0 Range expanded and incentive rate increased

Priority services for customers in vulnerable

circumstances

-1 to +1 N/A Removal of ODI

Thirlmere transfer into West Cumbria in AMP7 N/A -2 to +1 PR14 ODI continues until scheme finished

Bespoke ODIs with no interventions -80 to +110 -80 to +110 N/A

Bespoke ODI p10 to p90 range -300 to +385 -216 to +250

Exhibit excludes Manchester and Pennines resilience and strategic regional water resources ODIs, which will be determined later in the process. [1] In July, Ofwat signaled it wouldsignificantly reduce the incentive rate for water quality contacts, reducing the p10 to p90 range to approximately -£10 million to +£15 million.Sources: Company business plan, Ofwat, Moody's Investors Service

UUW’s cost targets may be difficult to achieve, though gap is smaller than peersA key reason that UUW was awarded fast-track status was its commitment to cut costs by 13%, excluding enhancement projects,compared with an average increase of 7% proposed by the rest of the industry, as calculated by Ofwat. UUW requested £4.5 billionin base costs, £0.9 billion for enhancement costs and £0.5 billion for household retail costs across AMP7 (based on slow-track draftdetermination classifications, after certain items were reclassified).

The regulator’s draft determination increased this challenge further, requiring a 15% overall reduction. UUW's total expenditureallowance at draft determinations is £110 million lower than requested (Exhibit 11), even after taking account of a £38 million increasein allowances alongside the slow-track draft determinations.

The reduction in enhancement expenditure primarily reflects the removal of proposed schemes from AMP7, such as £40 million forsupply-demand balance and £30 million for the transfer of private sewers to UUW's ownership, so the company is likely to achievethese reductions. More challenging are the reductions in base costs, in particular in wastewater where Ofwat set allowances 4.3%lower than the company's request.



Exhibit 11

Ofwat reduced UUW's total expenditure allowance by 2% from its business plan request£m 2017-18 prices

0 500 1,000 1,500 2,000 2,500

Base costs (water)

Base costs (wastewater)

Enhancements costs (wholesale)

Household retail

Totex (£m 2017-18 prices)UUW business plan Draft determinations

Excludes additional allowances for strategic water resources schemes and third party costs.Sources: Company business plan, Ofwat, Moody's Investors Service

UUW also proposed five company-specific adjustments to costs, reflecting considerations that it believes are not adequately reflectedin Ofwat's econometric modelling. In total, UUW requested £318 million in allowances for these five factors. Although Ofwat describedthe claims as “overall… of good quality,” at draft determinations it rejected four of them, only allowing an additional £57 million forManchester and Pennines resilience work (Exhibit 12). In response, the company withdrew two claims, but has continued to argue forfunding for the remaining claims, and raised an additional claim for £90 million of diversions costs which it says are not incorporatedwithin the total expenditure allowances.

Outside the cost assessment process, in its draft determinations Ofwat awarded UUW £25.7 million out of a £360 million pot to besplit between six water companies to deliver strategic water resources from the northwest of England to the south and southeast.UUW has argued that the £25.7 million allowance for strategic water resources is insufficient for it to proceed, and requested it beincreased to £45.3 million.

Exhibit 12

Ofwat rejected all but one of UUW's cost adjustment claims£m 2017-18 prices

Impact of

extreme

deprivation

Manchester &

Pennine

resilience

Surface water

runoff

Keeping

reservoirs

resilient

Distance to

landbank Diversions

Strategic water

resources Total

Allowance request in business plan 74 73 88 51 32 N/A N/A 318

Ofwat allowance at draft determination 0 57 0 0 0 N/A 26 83

Allowance request in UUW's response N/A 67 88 51 N/A 90 45 341

The cost adjustment claim for strategic water resources was added by Ofwat at draft determinations and the claim for diversions was added by the company in its response to Ofwat.Sources: Company business plan, Ofwat, Moody's Investors Service

UUW has also committed to fund £71 million of ring-fenced financial assistance schemes over the course of the price control, outsidethe total expenditure sharing mechanism. This will be entirely funded by the company through reduced dividends.

Much smaller total spending gap than peersAlthough we regard UUW's total expenditure allowance as challenging, the gap between the company's allowance at draftdetermination and its business plan proposal is significantly smaller than its peers (Exhibit 13), and the risk of significantunderperformance is therefore lower.



Exhibit 13

UUW faces a smaller efficiency challenge than peersDraft determinations wholesale and retail total expenditure allowance against business plan request

-15% -10% -5% 0% 5% 10% 15% 20% 25%

Anglian Water

Dŵr Cymru

SES Water

Yorkshire Water

Thames Water

Bristol Water

South East Water

South Staffs Water

Industry

Wessex Water

Northumbrian Water

Southern Water

South West Water

Affinity Water

United Utilities

Severn Trent (inc. HDD)

Portsmouth Water

Companies shown in green indicate fast-track status, while red denotes significant scrutiny business plans. Hafren Dyfrdwy (HDD) was classified as significant scrutiny, but its spendingwas considered very efficient; here it is included under fast-tracked Severn Trent Water, which owns Hafren Dyfrdwy. Portsmouth Water's plan excludes expenditure for the Havant Thicketreservoir.Sources: Ofwat, Moody's Investors Service

To the extent that UUW overspends against its total expenditure allowances, 50% will be recovered from customers after 2025. Thesharing rate is the same if the company underspends against its allowance.

UUW is keeping its options openCompanies that received fast-track determinations were given the option to accept “early certainty” in some areas, meaning that theywould not be subject to further review following the draft determination of the slow-track companies or at final determinations. UUWchose to reject the early certainty principle in its entirety, because it hoped that the regulator would take a more favourable view onthese aspects by the time of final determinations (Exhibit 14).

Exhibit 14

UUW is the only fast-track company that has chosen to leave open all areas where “early certainty” was offered United Utilities Severn Trent South West Water

Companies' own cost claims ✘ ✔ ✔

Bespoke performance commitment levels ✘ ✔ ✔

Financial incentives on performance commitments (PCs) ✘ Did not accept PCs for supply

interruptions, water quality

compliance, unplanned

outages

✔

Number of financial ODIs ✘ ✔ ✔

Deadbands, caps and collars ✘ Did not accept deadbands ✔

✔ Accepted early certainty principle; ✘ Rejected early certainty principle

Sources: Draft determinations, Moody's Investors Service analysis

The company believed it could achieve a more favourable outcome in several key areas, in particular:

» UUW argued that the internal sewer flooding ODI is disproportionally large relative to the overall package of incentives and hasrequested a less stringent performance target, which would reduce the p10-p90 range to a £14 million-£43 million penalty from the£45 million-£99 million penalty based on draft determinations.

» UUW also argued that it is not reasonable for Ofwat to require a 20% leakage reduction while allowing the company to recovercosts associated with a 15% reduction, and asked that the target be reduced or additional funding provided. On mains repairs, thecompany asked for the target to be increased to 119 from the 110 repairs per 1,000 km allowed in its draft determination, whichwould reduce but not eliminate the expected penalty.



» UUW provided additional customer research and argued that the financial ODI for systems thinking should be reinstated. As aconcession to Ofwat, it has proposed to increase the performance commitment to a “level two” capability maturity in 2021-22,from level one in its initial business plan, to make the commitment more stretching, resulting in a symmetric ±£74 million p10 top90 range.

In its draft determinations for the slow-track companies, Ofwat made a number of changes in areas where UUW had declined earlycertainty, most significantly on the financial incentives associated with performance commitments. However, as set out earlier inthis report, these changes have been generally unfavourable for UUW. For example, the mains repair target was cut to 108 from 110repairs/1,000km, rather than being increased as UUW had requested. Although reward rates were increased for internal sewer flooding,given forecast underperformance UUW is unlikely to benefit from this.

The industry will continue to argue for a more favourable outcome in these areas, including in the slow-track companies'representations on their draft determinations, and UUW will benefit from any improvement in common ODIs at final determinations.However, UUW is preparing for the possibility that its final determination is not materially improved, and has announced that it willspend an additional £100 million in 2019-20 to improve performance in areas with the largest potential penalties, such as sewerflooding and supply interruptions. This is addition to a £250 million investment in resilience previously announced.

Low leverage and borrowing cost provide some protection against cuts to allowed returnUUW’s business plan and Ofwat’s draft determinations were both based on the regulator's “early view” of required returns set inDecember 2017, which was based on a 3.19% allowed return, including retail margin, plus CPIH inflation. As a reward for gaining fast-track status, UUW was awarded an additional 0.1 percentage point return on regulatory equity, which the company has chosen toreceive as additional revenue rather than through an RCV adjustment.

Unlike the previous price review in 2014, UUW and the other fast-tracked companies were not offered early certainty on the allowedreturn. At the time of slow-track draft determinations, the return was cut by 21 bps, largely reflecting Ofwat's view that the requiredequity return had fallen (Exhibit 15). However, this figure was based on market data from February 2019, and Ofwat noted that largemarket movements between February and June would support an additional reduction of 37 bps (see Regulated water utilities – UK:Ofwat tightens the screws further, 26 July 2019), a total of nearly 60 bps compared to UUW's draft determination. Ofwat will notfinalise the parameters until December 2019.

A cut in allowed returns will intensify pressure on interest coverage ratios across the industry. For a hypothetical “notional” companywith 60% gearing, 33% of debt linked to inflation and average borrowing costs in line with the regulator's assumption, a cut to 2.71%(CPIH-stripped) would mean the adjusted interest coverage ratio (AICR) would fall to 1.15x in AMP7 from 1.3x in the current period.Most actual water companies have higher leverage and/or borrowing costs than the notional company and will face even more acutepressure.

However, UUW has net debt/RCV of around 60%, in line with the regulatory assumption and among the lowest in the industry, as wellas one of the lowest borrowing costs (Exhibit 16). Over the past three years, its AICR has averaged 2.8x, comfortably above our 1.7xguidance for the current rating.


https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1186347



Exhibit 15

Lower cost of equity assumption drives the cut in returnsBefore CPIH inflation Early view Draft determination Look ahead Ofgem sector decision

1

Calculation date 31/03/2017 28/02/2019 28/06/2019 29/03/2019

Gearing 60.0% 60.0% 60.0% 60.0%

Risk-free rate 0.10% -0.45% -0.99% -0.75%

Total market return 6.47% 6.50% 6.50% 6.50%

Observed equity beta of peers1,2 0.63 0.64 0.58 0.63

Enterprise value gearing of peers1,2 49.3% 54.7% 54.7% 49.8%

Debt beta 0.100 0.125 0.125 0.125

Equity beta of the notional company 0.77 0.71 0.64 0.75

Ofgem adjustments -0.39%

Allowed cost of equity 5.03% 4.47% 3.79% 4.32%

Embedded debt share of total debt 70% 80% 80%

Cost of new debt 1.37% 1.33% 0.59%

Cost of embedded debt 2.58% 2.46% 2.46%

Issuance costs 0.10% 0.10% 0.10%

Allowed cost of debt 2.32% 2.33% 2.18% 1.93%

Appointee allowed return 3.40% 3.19% 2.83% 2.88%

Retail net margin deduction -0.10% -0.11% -0.11%

Wholesale allowed return 3.30% 3.08% 2.71% 2.88%

Change from previous -0.22% -0.37%

[1] Ofwat's peer group consists of Severn Trent and United Utilities. Ofgem's peer group consists of National Grid, Pennon, Severn Trent and United Utilities. [2] Observed equity beta inlook-ahead is our estimate consistent with the unlevered beta cited by Ofwat.Sources: Ofwat, Moody's Investors Service estimates

If the allowed return is cut by 21 bps compared to UUW's draft determination, we estimate that UUW will still be able to maintain anAICR above our guidance even if it incurs ODI penalties and modestly overspends its totex allowances. The company's cash flow andAICR will be stronger if UUW can reduce its total expenditure to meet Ofwat's efficiency challenge or if it can improve operationalperformance to meet Ofwat's more stretching targets.

Exhibit 16

UUW has one of the lowest borrowing costs in the industry

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

Cash interest rates (2018/19) Nominal interest rates (2018/19)

Cost of debt allowance (cash terms) Cost of debt allowance (nominal terms)

Cost of debt allowance for embedded debt as set out in Ofwat’s draft determination for nominal cost of debt and assuming 33% of debt is inflation linked for cash cost of debt allowance,in line with the notional company assumptions.Sources: Companies' annual performance reports as at March 2019, Ofwat’s draft determinations, Moody’s Investors Service



However, if Ofwat chooses to reduce returns by the full 60 bps, there is a risk that UUW's AICR may fall modestly short of our guidancefor the current rating, absent, for example, stronger operational performance than expected. Further overspending could also result ininterest coverage metrics below guidance for the current rating, absent balance-sheet strengthening measures.

We expect that UUW will maintain its balanced financial policy, with net debt/RCV below 65% over the remainder of AMP6, takinginto account the company's published gearing target as well as its current dividend policy of setting growth in line with inflation. Weexpect UUW will maintain a similar financial policy in AMP7. We note, however, that the ultimate group parent company, UnitedUtilities Group PLC, is yet to announce its dividend policy for the 2020-25 period.

UUW will continue to benefit from the group's interest-rate management strategy of fixing debt service over a 10-year rolling forwardhorizon, as well as the high proportion of index-linked debt within the capital structure (around half of consolidated group debt), whichcontributes to lower cash interest costs.



Moody’s related publicationsIssuer reports:

» United Utilities Water Limited / United Utilities PLC - Update following fast-tracked business plan and rating affirmation, 27February 2019

» United Utilities PLC - Key Facts and Statistics - financial 2017–18, 26 November 2018

» United Utilities PLC - Credit Implications of the 2014 Price Review: Strong credit quality despite challenging environment, 12February 2015

Sector reports:

» Regulated water utilities – UK: Ofwat tightens the screws further, 26 July 2019

» Thames Water, Anglian Water, Yorkshire Water and Sutton & East Surrey Water: Ofwat warns that planned costs will not be funded,4 July 2019

» Regulated energy networks - UK: Labour Party details energy network nationalisation policy, 16 May 2019

» Regulated water utilities - UK: Ofwat's initial assessment credit positive for three companies, challenges others, 8 February 2019

» Regulated water utilities - UK: Covenanted financing structures help mitigate growing risks, 9 October 2018

» Regulated water utilities - UK: Regulator’s proposals undermine the stability and predictability of the regime, 22 May 2018

» Regulated water utilities - UK: Ofwat’s “call for change” may force companies to cut debt, 7 March 2018

» Regulated water utilities - UK: Government letter evidences continuing political and regulatory scrutiny, 6 February 2018

» GB Water and Regulated Energy Networks: FAQ on Labour's proposed renationalisation, 16 October 2017

Rating methodologies:

» Regulated Water Utilities, June 2018

Sector outlook:

» Regulated water utilities - UK: 2019 outlook negative as companies steer through troubled waters, 5 December 2018

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

Endnotes1 Draft determination actions and interventions, https://www.ofwat.gov.uk/wp-content/uploads/2019/04/United-Utilities-actions-and-interventions-

OC.pdf
















https://www.ofwat.gov.uk/wp-content/uploads/2019/04/United-Utilities-actions-and-interventions-OC.pdf

https://www.ofwat.gov.uk/wp-content/uploads/2019/04/United-Utilities-actions-and-interventions-OC.pdf


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