OREANDA-NEWS. Introducing retail competition for household customers of UK water companies would continue the trend of long-term credit-negative reforms in the sector, Fitch Ratings says. The precise impact on Fitch-rated companies would depend on the nature and pace of implementation, and in particular on the relationship between water companies and new retailers.

Ofwat, which regulates the water and sewerage sector in England and Wales, last week published its costs and benefits assessment of a competitive retail market for residential customers in England. It said the overall financial benefits would outweigh costs over 30 years under most scenarios.

However, companies would face "significant" set-up and ongoing costs, for example in changing billing systems and competing for customers, Ofwat said. We believe retail competition for household customers would be credit negative if implemented because these costs could put additional pressure on cash flow generation, as could failure to match potential lower revenues with reduced operating costs. We also note that Ofwat has not included any impact on financing costs in its assessment.

Introducing competition would also create uncertainty around counterparty risk. At present, this primarily consists of bad debt risk if customers do not pay their water bills. This is mitigated by regulatory provisions, such as bad debt allowances in regulatory allowed revenues, and a diverse customer base. Ofwat's scenario analysis notes that competition could incentivise water retailers to reduce bad debt costs through better management and more accurate billing.

In a competitive market, water companies' counterparty exposure would shift from end-users to new entrants to the retail market. The potential impact on Fitch-rated entities will depend on detailed regulatory provisions and the likely market structure that may emerge. Key areas to examine would include concentration risk, the credit quality of new counterparties, whether collateral is posted to cover payment interruption risk and the provisions in the Ofwat market code that would govern the relationship between wholesalers and retailers.

Competition for residential customers is one of several proposed reforms that are increasing business risk in the UK water sector. Others include introducing separate price controls for sludge and water resources, changes to the indexation of regulatory capital value (RCV) and regulatory allowed revenues, and alternative approaches to setting the cost of debt. By eroding cash flows, we believe these reforms could further weaken credit metrics such as net debt to regulated asset base, and post-maintenance and post-tax interest cover.

It is not clear when the UK government will decide whether to open the household market. If it decides in favour, we do not anticipate rapid implementation. Ofwat's scenarios see market opening taking between two and four years. We expect most companies to deliver minimum outputs set by the regulator, and some outperformance on capital and operating expenditure and revenues. This should keep within current credit ratio guidelines for their ratings until the next regulatory price control review in 2020.

The opening of the retail sector for non-household customers to competition in England, expected to start in April 2017, should not have a major impact as only 1%-2% of company revenues relate to retail services for businesses.