S&P: France-Based Integrated Energy Company EDF Downgraded To 'A-/A-2' On U. K. Approval Of Hinkley Point C; Outlook Stable
In addition, we lowered our long-term corporate credit ratings on EDF's U. K. subsidiaries EDF Energy PLC and EDF Energy Customers PLC to 'BBB-' from 'BBB'. The outlook on EDF Energy and EDF Energy Customers is stable. We also lowered our short-term corporate credit rating on EDF Energy PLC to 'A-3' from 'A-2'.
We lowered our long-term counterparty credit and financial strength ratings on EDF's captive insurance subsidiary, Wagram Insurance Co. Ltd., to 'BBB - from 'BBB'. The outlook on Wagram Insurance is stable.
We lowered our rating on the EDF's senior unsecured debt to 'A-' from 'A' and our rating on its junior subordinated hybrid securities to 'BB' from 'BB+'.
Our rating actions on EDF do not change our long - and short-term ratings on French power transmission network RTE (A+/Negative/A-1).
The downgrade primarily reflects our view that Hinkley Point C (HPC), which is a very large and highly complex nuclear new build project, will imply increased execution and contingency risks for EDF, while hampering its large additional investments at a time when it already generates negative free cash flow. We also consider that EDF simultaneously faces still high-risks related to the construction of its nuclear new build Normandy-based in Flamanville, which will not be operational until late 2018, according to the latest estimates.
We expect, however, that EDF will first receive proceeds of close to €1 billion from its sale of a 35% stake in HPC to its Chinese partner CGN, with the bulk of the investments disbursed only as of 2019. Also, we view positively the strength of the "Contract for Difference" (CfD) remuneration plan that EDF has signed with the U. K. government as part of the HPC transaction. But the CfD's effects will only surface in 2025, when HPC will likely be commissioned.
The HPC project includes the construction of two new third-generation nuclear reactors in Somerset, U. K., with a total capacity of 3,276 megawatts. The construction phase will likely last until 2025, and the new capacity from the plants will likely replace part of the existing nuclear fleet in the U. K. The project is also part of the U. K.'s energy plan to meet its targeted carbon footprint reduction. Once commissioned, the plant will benefit from a 35-year CfD signed with the U. K. government, with a guaranteed strike price of ?92.5/megawatts per hour (MWh) (2012 value), fully indexed to CPI. EDF will own 66.5% of HPC, and will fully consolidate the stake given its position as controlling shareholder.
EDF's board approved the group's final decision to invest in HPC in July 2016, and the U. K. government gave its green light to the project on Sept. 14, 2016.
In light of the downturn in power prices versus some years ago, we continue to believe that operating fundamentals have weakened for EDF. We believe, however, that the recently announced measures, including a €4 billion capital increase (expected within the next six months), scrip dividends, sizable asset disposals (of a targeted €10 billion) and a €1 billion cost-cutting plan, will help reduce EDF's adjusted debt over the next three years, which is key for the rating, and partly mitigate its higher operational risk profile. With respect to the disposal program, we understand the bulk relates to the group's 49% stake in RTE, regarding which EDF entered into exclusive negotiations in July with state-owned Caisse des Depots et Consignations and its subsidiary CNP Assurances.
We continue to assess EDF's business risk profile as strong, notwithstanding the following increased challenges. In addition to the construction and contingent risks related to HPC (reflected in our negative comparable ratings analysis modifier), these include the increasing share of revenues that are derived from unregulated activities following the partial liberalization of the French energy market. This coincides with a sharp decrease in power prices, well below the regulated ARENH reference price, which was until recently considered as a sustainable floor price for power in France. This is because we see coal and interconnections (notably with Germany) as now being the main price setters in France. We also consider negatively the less-than-anticipated protected patterns of the French power market, given the higher exposure to fuel commodity prices and the mostly outright production profile of EDF, through its nuclear reactor fleet and its hydro plants, which together account for about 80% of EDF's annual output. Although we factor in our assessment of the implementation of a carbon dioxide (CO2) price floor in France from 2018 and we recognize the political willingness to implement a capacity market, we also take into account the lack of flexibility to create a markedly more favorable market design in France, due to affordability issues and EU limitations.
Despite the ongoing challenges that hurt EDF's credit quality, key strengths remain the group's significant size, the contribution from its regulated network activities in France, and its low carbon generation fleet, which may benefit from a higher carbon price over time. We also see some flexibility in its cost structure, notably because the management did not implement hard cuts in previous years, especially compared with sector peers. Another degree of financial flexibility lies in the asset disposal program. This is notably supported by EDF's international assets in non-core markets, which we believe have high value but low EBITDA contributions. The group is also now preparing to sell its stake in RTE.
As part of our assessment of EDF's significant financial risk profile, we benchmark EDF's credit metrics, notably our adjusted funds from operations (FFO)-to-debt and debt-to-EBITDA ratios, against our medial volatility table. We use this approach since EDF derives more than one-third of its earnings from France's supportive regulated activities. EDF's sizable investment plans include however massive maintenance and upgrade expenditures on the existing nuclear fleet and new nuclear build in France. We anticipate that at current power prices, these high investments translate into negative free operating cash flows until 2019. That said, we expect adjusted leverage will decrease as a result of important asset disposals, the announced € 4 billion capital increase, and scrip dividends in 2016 and 2017. Our assessment of the financial risk profile is also underpinned by EDF's benefits from excellent market access and its proactive and prudent management of liabilities.
Our adjusted credit metrics on EDF are particularly affected by the relative weight of EDF's nonfinancial obligations (pensions and nuclear obligations, which amounted to a combined €27.2 billion at year-end 2015, out of adjusted debt of €75.6 billion). We see some volatility that may emerge from actuarial assumptions used to value these obligations, notably on nuclear provisions--and a potential risk of deterioration in our adjusted credit metrics. At the same time, we note that EDF recently decided to extend the accounting life of part of its nuclear fleet in France by 10 years (to 50 years), which has enabled a €2.1 billion reduction in nuclear provisions.
Lastly, our assessment of a high likelihood for extraordinary government support to EDF, if needed, is underpinned by the French government's recent announcements, particularly regarding the planned capital increase and the scrip dividends. We also see the government's involvement in EDF's strategy and financial health as another key driver in our assessment. We factor the likelihood of government support into our rating on EDF by including a three-notch uplift from our 'bbb-' assessment of its stand-alone credit profile (SACP).
We base our opinion of the high likelihood of support on our view of EDF's important role for France and very strong link with the French government. That said, we would likely revise downward our assessment of likelihood for exceptional government support if we do not see effective and timely implementation of the remedy measures for EDF.
The stable outlook takes into account the remedy plan set by EDF and the French government, including the implementation of the announced capital increase and disposal of the stake in RTE in the coming quarters. As a result, we foresee EDF's debt decreasing over the next two years. Adjusted FFO to debt will likely stabilize with some financial headroom above the 15% threshold, which we currently see as the minimum for a 'bbb-' SACP.
We might consider a negative rating action on EDF if it doesn't effectively implement the above-mentioned remedy solutions, including asset disposals, the planned capital increase, and efficiency gains. This will, in turn, slow the group's debt reduction and accentuate pressure on its credit profile. Specific risk factors for EDF include the evolution of power prices over the next few years, although they have recently recovered to levels slightly above our baseline scenario, as well as uncertainty about EDF's Flamanville nuclear power plant.
A downgrade of France by more than one notch would also trigger a downgrade of EDF. Moreover, a downward revision of our assessment on the likelihood of extraordinary support from the French state to EDF could lead to a downgrade of the group.
Rating upside is remote at this stage, given that the group has yet to execute on its deleveraging plan and continues to generate negative free cash flows. We could envisage a positive rating action in the event of a combination of substantial improvements in European energy markets, commissioning of Flamanville with no further delay or cost inflation, EDF sustainably generating positive free cash flows after dividends, and a ratio of FFO to debt comfortably above 18%.