Fitch: Lower Gas Regulated WACC Negative for REN; No Rating Impact
The Portuguese regulator Entidade Reguladora dos Servicos Energeticos (ERSE) has revised the weighted average cost of capital (WACC) formula inputs to align gas methodologies with those in place for electricity. The application of the new gas transport, storage and regasification methodology for the return on capital leads to a base WACC (nominal pre-tax) of 5.9% (8% base WACC for the previous period 2013-2016; 7.3% considering the preliminary indexation to the 10-year Portuguese bond yield for 2015-2016 tariff year).
The review has eliminated the historical risk premium on the rate of return for gas versus that of electricity. On the other hand, the annual indexation mechanism with the Portuguese 10-year government bond yield, together with the floor and the cap protection, has been maintained (although the cap and floor have been tightened to 5.4% and 9% respectively from 7.3% and 10.5%), given continuing perception of economic and financial instability in Portugal.
Fitch believes that the downward revision of remuneration for Portuguese networks is consistent with the current low interest rate and the credit risk environments in Portugal, with 10-year bond Portuguese yields falling to 2.8% in 1Q16 from 6.3% in 1Q13 (when the base rate of return was defined for the previous period July 2013-June 2016). This is in line with some other EU regulators' decisions (see "Fitch: Return on Capital Update is Credit Positive for Italian Networks" published on 4 December 2015 at www. fitchratings. com).
Fitch continues to take a positive view on the Portuguese gas regulatory framework given the independence of the Portuguese regulator and the stable framework providing earnings visibility up to 2019. This compares with some other European regulatory frameworks, which have longer visibility of five or more years.
Cost of equity (nominal, pre-tax) in the WACC formula is in the range of 7.29% (minimum) and 8.07% (maximum), reduced from 10.4%-10.6% previously. The formula calculates the equity risk premium from the mature market return premium (4.2%-4.6%), based on long-term historical evidence, plus the country risk premium (Portugal; 1.68%). The risk-free rate (1.73%) is now based on the last five-year average of the 10-year bond yield of four European 'AAA'-rated countries, as is the case for electricity. The beta's value for REN's activities is broadly flat in the range of 0.58-0.63 and the tax rate is at 29.5%, versus 31.5% previously.
The spread considered for defining the cost of debt (nominal, pre-tax) has been increased to 2.5% from 1%; however, the total cost of debt has been reduced to 4.23% from 5.9% as the formula, similar to that for the electricity sector, no longer considers the country risk premium in the calculation of the cost of debt. The gearing ratio has been reduced to 50% from 53%.
Fitch's affirmation of REN's ratings in March already factored in our expectation of a drop in the WACC from July 2016. The WACC levels defined by the regulator are in line with those conservatively included in Fitch's rating case at around 6%. Although REN's earnings for the period July 2016 to June 2019 will be negatively affected by the lower returns we expect this to be partially offset by the natural hedge provided by decreasing financial costs to 3.1% in 2018 from 4.1% in 2015. REN's funds from operations (FFO) adjusted net leverage increases to 6.7x in 2016-2018 from 5.7x on average for 2013-2015, leaving little leverage headroom for its rating. Revenues for gas activities were around 32% of REN's total revenues in 2015.
In addition to the WACC revision, the new regulatory period for gas transport has introduced a move to incentive-based remuneration for the system's technical management activity, an updated cost base reference to 2014 and stricter efficiency targets for opex.
For gas distribution the base WACC has been reduced to a rate of return 6.2% from 9% previously (preliminary rate of return for 2015-2016 including indexation was 7.94%). EDP - Energias de Portugal S. A. (BBB-/Stable), which operates in gas distribution through its wholly owned Portgas subsidiary, should see minimal impact on leverage due to the limited share of gas distribution (EUR59m revenues for 2015; 0.4% of total revenues) in its total business.