The regulatory ring-fencing risk for the holdcos of U.K.-regulated utilities.


  • We have revised our view of the regulatory ring-fencing risk for the holdcos of U.K.-regulated utilities. Absent structural mitigants or parent support, we now notch the corporate credit ratings on these holdcos one notch lower than their opcos, instead of two notches previously when the operating subsidiary was rated 'BBB+'.
  • In our view, the risk of ring-fencing is now reduced compared to what we previously assumed at the 'BBB+' rating level. This reflects the sector's track-record of proactive management of regulatory risk and financial policy actions, such as curbing dividends or capital strengthening, well before ratings reached 'BBB-' with a negative outlook or CreditWatch placement, the level at which the regulator would step in.

  • As a result we now apply a one-notch downward adjustment to the issue ratings from the corporate credit ratings on these holdcos. This reflects the fact that such debt is materially disadvantaged compared with the bulk of group debt concentrated at the regulated operating subsidiaries and typically results in a two-notch differential between the rating of the debt issued by operating and holding companies.
  • We are removing the issue ratings on United Utilities and Severn Trent from "under criteria observation" (UCO) where they were placed on Sept. 21, 2017.
  • We are lowering by one notch the debt ratings on United Utilities' holdco to 'BBB' from 'BBB+', while affirming the 'BBB+' corporate credit ratings. The latter is one notch below its 'A-' rated operating subsidiary, United Utilities Water Ltd.
  • In addition, we are raising by one notch the corporate credit rating on the following holdcos: Severn Trent PLC and South Staffordshire PLC, both to 'BBB'; and UK Power Networks, North West Electricity Networks (NWEN), and Northumbrian Water all to 'BBB+'. All respective debt issue ratings are unchanged.
  • All corporate credit ratings and issue ratings on the regulated operating subsidiaries of these holdcos are unchanged. These actions solely reflect a change in criteria, with no change to the respective groups' fundamental credit quality.

We reflect these risks separately, both at the corporate credit rating and 
issue rating levels:

  • Issue ratings: We now apply a one-notch downward adjustment to the debt of all unregulated holdcos to reflect subordination risk. This reflects the fact that holdco creditors are second ranking and the bulk of the debt is concentrated at operating subsidiaries. We acknowledge that the recovery values for holdco creditors could be high but are also highly uncertain due to the unpredictable default path.

  • Corporate credit rating: We now notch down the corporate credit ratings on our rated unregulated holdcos (those that do not benefit from structural features) by one notch to reflect the potential for regulatory ring-fencing. Previously, we applied a two-notch differential for certain holdcos when their operating companies were rated 'BBB+' but we now see the risk of ring-fencing as more remote. U.K.-regulated utilities show relatively good rating stability and the majority of operating subsidiaries are rated 'A-' and 'BBB+'. Importantly, companies are willing to take supportive measures when credit quality is under pressure, well before it approaches 'BBB-'. For instance they will operate at lower leverage levels by reducing dividends, raising equity, or implementing cost efficiencies. For holdcos with operating subsidiaries rated 'A-' we already notch down the holdco by one notch: this is still our approach.
We would, however, likely increase the notching differential if the rating on 
an operating subsidiary were to be lowered. As the rating on a regulated 
operating company falls toward 'BBB-' the risk of a lock-up of dividends 
increases exponentially--at which point we could consider rating the holdco 
several categories lower.

We also note that the risk of regulatory cash lock-up for holdcos can be 
partly mitigated through structural protections such as intercreditor 
agreements, together with liquidity facilities, covenants, and a stand-still 
period at the holdco; or via potential support from a parent with stronger 
credit quality. In these cases, the rating on the holdco could be the same as 
that on the regulated operating company.

In light of the above, we have raised by one notch the corporate credit 
ratings on the holdcos for five complex U.K. utility groups: Severn Trent PLC, 
South Staffordshire PLC, UK Power Networks, North West Electricity Networks 
(NWEN), and Northumbrian Water (see individual rationales and outlooks below). 
The issue ratings on debt issued by these groups do not change, despite this 
revised approach, because debt issued is now rated one notch lower than the 
respective corporate credit ratings due to structural subordination. However, 
we lowered by one notch the issue ratings on the debt issued by United 
Utilities as we were not previously notching for structural subordination. 

Regulatory ring-fencing mechanisms designed by the U.K. regulators for water 
companies (Ofwat) and networks companies (Ofgem) aim to safeguard the 
provision of essential services to gas, electricity, and water customers. They 
include a wide-ranging series of measures that aim to prevent financial 
weakening of regulated utilities such as annual certification of financial 
resources, prohibition of guarantees and cross-default and asset pledges, as 
well as restrictions on business activities and disposals. We believe that 
these measures could partially insulate the regulated utilities, but not by 
themselves shield the operating subsidiary from financial difficulty at the 
parent level. 

The second set of measures seeks to restore credit quality after it has 
deteriorated to 'BBB-' with a negative outlook or CreditWatch placement. The 
U.K. regulators have a duty and the powers to intervene and enact a cash 
lock-up where the regulators must give consent to all transactions except 
payments for goods and services. The provision also empowers the regulator to 
prohibit dividends that could have detrimental consequences for debtholders at 
holding companies. 
 
UNITED UTILITIES PLC

The lowering of the debt issue rating to 'BBB' from 'BBB+' solely reflects a 
change in criteria, with no change to the group's fundamental credit quality. 
The lower rating reflects the structural subordination of debt at the holdco 
in relation to the debt located at the operating company.

The corporate credit rating on United Utilities PLC is unchanged at 'BBB+'. It 
is one notch lower than its core operating subsidiary United Utilities Water 
Ltd., which is rated 'A-'. This is because the holdco creditors face possible 
risk of reduced cash flows if the regulatory ring-fence is activated; albeit 
we note the risk is remote at the current rating level.

The stable outlook on both entities reflects a gradual increase in financial 
headroom toward funds from operations (FFO) to debt of 11% and an improving 
operating performance. It also reflects ongoing operating and financial-costs 
outperformance and an ongoing prudent financial policy, with relatively low 
debt to regulated capital value at about 60%.

We think that the next regulatory period might be challenging for the sector. 
That said, the group's conservative financial policy, regulatory rewards for 
operating performance, and additional spending on operating performance should 
position it well to negotiate the next regulatory period and maintain strong 
credit metrics.