OREANDA-NEWS. Fitch Ratings has assigned PGE Sweden AB (publ)'s upcoming bonds an expected foreign currency senior unsecured rating of 'BBB+(EXP)'.

The upcoming notes are rated at the same level as PGE Polska Grupa Energetyczna S.A. (PGE, BBB+/Stable) to reflect unconditional and irrevocable guarantee by PGE. The notes will be issued under PGE Sweden's EUR2bn euro medium-term note programme (BBB+) guaranteed by PGE. The final rating is contingent upon the receipt of final documents conforming to information already received. A full list of ratings is available at the end of this commentary.

KEY RATING DRIVERS
Conservative Financial Profile
PGE is among the least indebted large European utilities rated by Fitch, with close to zero net leverage. However, PGE has also a high exposure to the challenging conventional power generation (61% of 2014 EBITDA) sector and a low share of more predictable, regulated income from distribution (28%) compared with its European peers.

Strong Market Position
The ratings reflect PGE's vertically integrated operations in the Polish electricity market, strong position in power generation (about 40% of the country's conventional generation), lower costs of electricity production than the Polish average, and its strong position in electricity distribution and supply (26% and 30% market shares, respectively).

Projected Increase in Leverage
Fitch projects funds from operations (FFO) adjusted net leverage to increase to 2x-2.5x in 2017 and 3x by 2020 from close to zero at end-June 2015, due to projected negative free cash flow (FCF) driven by large capex. PGE's nuclear power plant project is currently beyond the five-year rating horizon. We view net leverage of 3x as the maximum level for the ratings.

Challenging Generation
PGE's generation business is under pressure from declining margins, decreasing free carbon dioxide (CO2) allowances, and a rising share of renewables supported by subsidies. In addition, 2015 and 2016 will be the last two years of the compensation scheme for the termination of PGE's long-term power purchase agreements.

Limited Fuel Diversification
Lignite-fired and hard coal-fired plants accounted for 71% and 22% of PGE's 2014 generation, respectively, resulting in significant exposure to rising CO2 costs, although this is mitigated by the gradual phasing-out of free CO2 allowances in 2013-2020. The company's average CO2 emissions of one tonne per megawatt hour (MWh) are high. However, PGE is planning to reduce its emissions by 2018.

Generation Asset Base
PGE's conventional generation fleet has on average a better position in the country's merit order than its Polish peers'. This is because PGE's lignite-fired power plants have a lower cost base than hard coal-fired plants, which are price-setters in the country, and also because the average age of PGE's generation assets is lower than its Polish peers' (26 years against 30-40 years), allowing for better efficiency and operational ratios. However, the significant decline in domestic coal prices in the past 12 months has reduced the competitive advantage of PGE's lignite-fired power plants against hard coal-fired plants due to the fairly stable cost of lignite from PGE's own mines.

Asset Impairment
The weaker expected profitability of PGE's lignite-fired power plants was the main reason for a large PLN8.8bn (EUR2.1bn) asset impairment announced in August 2015. Fitch views the impairment as neutral to the ratings due to its non-cash character. However, the underlying assumptions adopted by management in the impairment test are quite rigorous, and if they materialise they would have a negative impact on PGE's EBITDA and cash flows, which could be negative for the ratings.

Low Share of Regulated EBITDA
The EBITDA share of PGE's predictable, regulated distribution business (28% of 2014 EBITDA) is low compared with 60-70% for its Polish peers (Energa S.A., TAURON Polska Energia S.A. and ENEA S.A, all three rated BBB/Stable). Fitch expects that over the medium term the share of PGE's regulated EBITDA will rise and stabilise at 35%, partly due to the weaker performance of the generation segment.

Rated on Standalone Basis
PGE is 58%-owned by the Polish state (A-/Stable), but Fitch rates it on a standalone basis because we assess legal, operational and strategic links with the state as moderate based on our Parent and Subsidiary Rating Linkage criteria.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for PGE include:

-No major shifts in wholesale electricity prices within the five-year forecast period;
-Recovery in coal prices for PGE to 2013's levels and around a 50% increase in the CO2 market price within a five-year rating horizon;
-Increased electricity production volumes from 2019, due to commissioning of new blocks in Opole and Turow;
-Stable distribution and sales volumes;
-Capex of PLN36bn-PLN37bn in 2015-2019.

RATING SENSITIVITIES
Positive: Future developments that could, individually or collectively, lead to positive rating action include:
- PGE currently has large financial headroom in its ratings, although this is likely to gradually decrease by 2017 due to rising debt. Projected FFO adjusted net leverage below 2x (2014: minus 0.1x) on a sustained basis, supported by management's more conservative leverage target, could be positive for the ratings.
- A more diversified fuel generation mix and lower CO2 emissions per MWh, which together with planned efficiency improvements, would result in a stronger business profile and benefit ratings

Negative: Future developments that may, individually or collectively lead to negative rating action include:
- Deterioration of credit ratios, including FFO adjusted net leverage above 3x and FFO fixed charge cover below 5x (2014: 90x) on a sustained basis.
- Acquisitions of stakes in coal mines or other form of support for state-owned mining companies under financial pressure, such as Kompania Weglowa - leading to net leverage above 3x or substantially worsening PGE's business profile, could be negative for PGE's ratings.

LIQUIDITY
At end-June 2015 PGE had PLN4.2bn of unrestricted cash and cash equivalents as well as PLN2.4bn of committed unused facilities against short-term debt of PLN252m and Fitch-projected negative FCF of about PLN5bn for 2015. PGE plans to substantially increase its debt in the next five years to co-fund the capex plan.

On 7 September 2015 PGE entered into a new loan agreement with consortium of banks, securing a term loan of up to PLN3.6bn and a revolving loan of up to PLN1.9bn.

Fitch published a full rating report on PGE on 10 September with a more detailed commentary on the company, including recent developments related to PGE's asset impairment and the Polish government's plan to support coal mining company Kompania Weglowa.

FULL LIST OF RATINGS
PGE Polska Grupa Energetyczna S.A.
Long-term foreign and local currency IDRs: 'BBB+'; Outlook Stable
Foreign and local currency senior unsecured ratings: 'BBB+'
National Long-term rating: 'AA-(pol)'; Outlook Stable
National senior unsecured rating: 'AA-(pol)'

PGE Sweden AB (publ), guaranteed by PGE Polska Grupa Energetyczna S.A.
Foreign currency senior unsecured rating: 'BBB+'
Foreign currency senior unsecured rating: 'BBB+(EXP)' for upcoming bonds.