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Regulatory ‘financial tramlines’ for Scottish Water

This note considers the key determinants of a credit rating of a water and sewerage company (WASC), what may be the most appropriate credit metrics to target, and whether it is possible to find a ‘sweet spot’ that optimises the trade-off between the price and the availability of debt. 

The rating of a water and sewerage business is fundamentally determined by three factors: the nature of the regulatory environment, the asset ownership model and credit metrics. In looking to optimise Scottish Water’s debt-raising capacity, this indicates the importance of a stable and transparent regulatory regime coupled with strong and predictable cash flows. The basic rating created by these factors may be enhanced if the business is well run, well governed, focused on its core activities, and if further creditor protection is provided. Banks and credit rating agencies interviewed stressed the importance of several non-financial aspects, particularly corporate governance, the independence of regulation, the goals and objectives of the company, and the company’s efficiency.
While investors would need reassurance on these operational, governance and ring-fencing provisions, and other non-financial aspects, in the event that Scottish Water raises finance in bond markets, the immediate priority at this stage is to determine a clear set of ‘financial tramlines’ that will be at the core of the next price control. The analysis of the work done by the rating agencies and of the covenants that companies have offered to the market would suggest that the two most important financial metrics are gearing and adjusted interest cover. These ratios carry the highest weight in the rating methodologies, and are the most commonly adopted in bond and bank documentation and contracts. Most interviewees were of the view that investors will look for those credit metrics that they are most accustomed to (with a preference for metrics that are investment and cash-based rather than accounting standard-based), and that comparison of those metrics to corresponding ratios for England and Wales (E&W) water companies would be unavoidable.
Typically, water companies have a family credit rating between A/A2 and BBB+/Baa1, with the lower rating being most usual. This has allowed the companies to raise around two-thirds of their capital via debt if they are not ring-fenced, or around 80% if they are prepared to offer further creditor protections. Over the long term, companies raise finance at around 140bp above gilt yields with an A/A2 rating, and 190bp above gilt yields with a BBB+/Baa1 rating, implying that a credit rating ‘notch’ is worth around 15–20bp. However, this is a significant oversimplification. In practice, the debt premium (relative to gilts) that companies face has at least as much to do with the market conditions at the time of issuance as it is to do with the credit rating attributed to the bond issued. It is difficult to conclude that there is a particular ‘sweet spot’ that optimises the balance between the price and the availability of debt capital. Nevertheless, it is the case that there is a positive relationship between companies’ cost of borrowing and gearing level, and that the gap between A rated and BBB rated debt widens in stressed capital markets.

Based on established market practice, and as confirmed during the interviews, investors would not be surprised to see the central tramline for Scottish Water reflecting an A–/A3 credit rating, with the upper and lower limits being A/A2 and BBB+/Baa1. The level of debt that can be taken on for that rating does depend, however, on the strength of the regulatory system and the extent of additional creditor protections that are offered.