Lower RPI could lead to dividend drought

Changes being considered by the UK government leading to a lower RPI could impact UK water companies through slower revenue and dividend growth, a mismatch between index-linked debt and the revised indicator, and even potential early bond redemptions, Moody’s warns.

Moody’s, the ratings agency, has issued a note stating that potential changes being considered by the UK government to the Retail Price Index (RPI), a common inflation indicator, “would be credit negative” for UK water companies.

According to Moody’s, the UK’s Office for National Statistics is considering three potential changes to the way RPI is currently calculated. The changes are intended to bring RPI in line with the Consumer Prices Index, the country’s other headline inflation measure, and could effectively shave between 50 basis points and 100 basis points off the RPI.

Should this happen, Moody’s foresees a number of possible impacts for UK water companies, the most harmful of which, arguably, would be slower revenue and dividend growth:

“A lower RPI would lead to slower revenue growth, potentially at a lower rate compared to a company’s expenditure. As companies are mainly financed with fixed-rate debt, a reduction in future revenue would lead to weaker interest coverage ratios, a credit negative. Similarly, lower RAV [regulated asset value] growth could require an adjustment to dividends to keep gearing constant, potentially causing problems for any holding company debt,” Scott Phillips, assistant vice president at Moody's warns.

How that debt would behave facing a revised RPI is another interesting subject. On the one hand, Moody’s, highlights that “index-linked debt has historically allowed companies to efficiently align assets and liabilities and may mitigate some of the negative effect of a lower RPI”. But on the other, bonds typically have clauses protecting bondholders against changes to the way an index is calculated. 

Should they be triggered, “revenues and RAV would then be inflated using the new, lower RPI while debt would use a higher, modified value, leading to a mismatch. This would result in a weakening of some financial ratios, a credit negative,” Phillips states.

Finally, changes to the RPI could potentially trigger an early redemption of bonds, although Phillips considers this the most unlikely of the potential impacts of an RPI change:

“There is a low risk that some bonds would need to be redeemed if adjustments to the index cannot be agreed. If companies were unable to issue index-linked debt, they could be forced to refinance with fixed-coupon debt, negatively affecting their interest coverage ratios.”

To read the full Moody's report, please click here

A lower RPI, if it materialises, would be the latest in a series of setbacks for the UK’s mostly privately managed water sector. The industry is already at loggerheads with Ofwat over the regulator’s proposed changes to the licensing regime, opening the door to a lengthy referral to the Competition Commission.

And a few weeks ago, a flurry of newspaper articles accused the sector of tax dodging, overleveraging, and excessive dividend practices, among other criticisms. There were also calls for an investigation of the sector by parliamentary watchdog the Public Accounts Committee.