S&P: Scotland And Southern Gas Networks Ratings Raised To 'BBB+' On Improved Credit Metrics; Outlook Stable
At the same time, we raised our issue rating on Scotia's senior unsecured debt to 'BBB+' from 'BBB'.
The upgrade reflects Scotia's improving financial risk profile on the back of continuous outperformance of the operating allowances set by the regulator, the Office of Gas and Electricity Markets (Ofgem). We anticipate that adjusted FFO to debt will be slightly above 9% in 2017-2018--when Scotia is required to return past outperformance to customers--but close to 10% thereafter until the end of the regulatory period in 2021. We still forecast recurrent negative discretionary cash flow (DCF) on the back of potentially large dividend payments, which constrain Scotia's financial risk profile. However, we understand that the dividends are discretionary and the owners aim to maintain debt to regulatory asset value (RAV) within its target of 75%.
Our assessment of Scotia's significant financial risk profile incorporates our view of the company's low-risk, stable, and predictable cash flow generation over the 2013-2021 regulatory period, offset by its sizable debt burden. The financial risk profile is also supported by positive free operating cash flow (FOCF; cash flows after capital expenditure [capex]). We apply the financial benchmark--that is, the low volatility table--to reflect our assessment of Scotia's strong regulatory advantage.
Our excellent assessment of Scotia's business risk reflects its two gas distribution network (GDN) low-risk operations, which contribute to stable and predictable revenue and cash flow streams. These are underpinned by limited volume risk and the generally credit-supportive U. K. regulatory regime in the GDN sector, which ensures a high degree of stability and predictability of earnings and cash flows. The strength of Ofgem and its framework is reflected in our assessment of Scotia's strong regulatory advantage (see "Why U. K. Utilities' Regulatory Frameworks Merit A "Strong" Regulatory Advantage Assessment," published on Dec. 11, 2013 on Ratings Direct).
Over the longer term, we think that Scotia will benefit from its focus on incentives and output under RIIO (revenues = incentives + innovation + output), and the additional return on equity that the RIIO model allows for outperformance. Scotia has continued to outperform the operating allowances set by Ofgem, while achieving its regulatory targets. During the first three years of the current regulatory period, the group achieved overall return on regulatory equity of about 15% (including financing outperformance), compared to the baseline real post tax cost of equity of 6.7%. In addition, Scotia ranked second and fourth for its respective networks on customer satisfaction output scores, which will drive a significant part of the incentive income going forward.
Our base case assumes: Growth of 1.5% and 0.9% in the U. K. in 2016 and 2017, respectively. That said, Scotia is relatively resilient to economic conditions, as its earnings under the U. K. regulatory framework are insulated from fluctuations in electricity and gas demand. U. K. retail price index to be slightly higher than our consumer price index forecasts of 1.8% in 2016 and 3.0% in 2017, due to an index adjustment of 0.5% in 2016 and 0.7% in 2017. Revenues rising slightly in 2016-2017 by about 3% but then declining slightly. The decline in 2017-2018 is expected and largely driven by a rebate of a proportion of realized operating efficiencies to customers. Capex of ?2.7 billion over the current eight-year regulatory period. Average yearly capex of about ?340 million as per Scotia's business plan. Discretionary dividend payments based on a 77.5% gearing policy. Some outperformance on total expenditure (operating expenses and capex) as a result of efficiency initiatives in line with the company's track record. We treat the ?533.6 million shareholder loan as debt, because it does not fully meet our criteria for equity treatment of non-common equity provided by strategic owners. Based on these assumptions, we arrive at the following credit measures: FFO to debt to increase to above 9% over the next two years and 10% thereafter. Positive FOCF over our 24-month rating horizon. We use negative comparable rating analysis modifier to reflect the fact that Scotia's financial risk profile will remain at the bottom end of the significant financial risk profile for the remaining regulatory period (until 2021).
Under our criteria, the rating on monoline-insured debt reflects the higher of the rating on the monoline insurer and Standard & Poor's underlying rating. Therefore, the rating on the senior unsecured debt guaranteed by Assured Guaranty (Europe) Ltd. reflects the higher SPUR.
The stable outlook reflects our view that U. K.-based GDN companies Scotland Gas Networks and Southern Gas Networks will maintain a strong operational performance. The outlook also assumes that the consolidated group at the level of Scotia Gas Networks Ltd. (Scotia Gas; not rated)--which is the focus of our analysis--will exhibit a stable financial profile. In particular, we anticipate that the group's adjusted FFO to debt will remain sustainably above 9%.
We could consider lowering the ratings if Scotia reports a weaker operating performance or reduced profitability, which could result from cost overruns, compared with regulatory assumptions. We could also consider a negative rating action if our forecast for Scotia's adjusted FFO-to-debt ratio falls below 9% over an extended period. In addition, we could consider lower the ratings if we see a more aggressive shareholder attitude. This would be evident, for example, from higher dividend payouts than we anticipate. We understand that dividend payouts are discretionary.
We consider an upgrade unlikely in the near term. That said, we could consider raising the ratings if Scotia's financial profile improves significantly, for example, if adjusted FFO to debt comfortably exceeded 11% and financial policies became more moderate, resulting in lower leverage than current levels.