Fitch Ratings has revised National Grid Plc's (NG), National Grid Electricity Transmission plc's (NGET) and National Grid Gas plc's (NGG) Outlook to Negative from Stable.
Fitch has affirmed Long-Term Issuer Default Rating (IDR) for NG at 'BBB' and NGET and NGG at 'A-'. We also affirmed the senior unsecured debt ratings for NG at 'BBB+' and for NGET and NGG at 'A'. NGET and NGG are wholly owned operating subsidiaries of NG and British Transco International Finance BV's bonds are guaranteed by NGG. A full list of rating actions is available below.
The Negative Outlooks reflects our expectation of funds from operations (FFO) net leverage above our negative sensitivity until financial year ending March 2022 (FY22) and depleted leverage headroom for FY23 and FY24. This is due mainly to reduced earnings prospect from the draft determinations (DDs) for the upcoming regulatory price control (RIIO T2; April 2021 to March 2026) and the impact of COVID-19 on NG's US operations with uncertain recovery timeframe, as well as NG's aggressive investment plan, which Fitch estimates at about GBP5.5 billion for FY21.
The affirmation reflects the availability of mitigating measures, which could be implemented to maintain credit metrics in line with our rating sensitivities. If deleveraging takes longer than expected and no mitigating factors are implemented, this could be negative for the rating.
The affirmation also factors in the adequate financial profiles of NGET and NGG, where we anticipate NGET's operational and regulatory performance could lead to some incentive income over RIIO T2. Our view is supported by the regulated and diversified nature as well as the scale of NG's business providing good earnings visibility and by the group's consistent operational and financial performance.
KEY RATING DRIVERS
Credit Metrics above Rating Sensitivities: The Negative Outlook signals our medium-term view that the downside risks could lead to a one-notch downgrade, given the depleted rating headroom at 'BBB', despite our view of moderately higher debt capacity for NG. Fitch expects FFO net leverage to peak at about 7.5x in FY21 and FY22, which is sharply above our negative rating sensitivity of 6.3x (revised from 6.0x). This is due to the transition to RIIO-T2 from RIIO-T1 price controls (including one-off adjustments), deferral of rate increases across New York and incremental COVID-19 related costs.
Leverage May Improve by FY23: NG's ability to return to net leverage in the low 6.0x range by FY23 depends on the outcome of RIIO-T2 final determination (FD), US rate cases and the timing and extent of COVID-19-related cost recovery. An important consideration for future rating action will be how NG manages its cash deployment and debt levels during the downturn in FY21-FY22. A longer deleveraging timeframe would likely result in a negative rating action.
Moderately Higher Debt Capacity: Fitch has revised upwards the debt capacity (FFO net leverage and gearing (net debt/regulated asset base)) for NG's US regulated businesses following our updated peer comparison with rated US regulated peers. Fitch considers UK regulated utilities to have higher debt capacity than US regulated utilities, due to the differences in regulatory environments. Within the US, we view Federal Energy Regulatory Commission (FERC) regulation as more favourable than state regulation and NG's US businesses as overall comparable to the profiles of Brooklyn Union Gas Company (KEDNY, BBB+/Stable) and KeySpan Gas East Corporation (KEDLI, BBB+/Stable).
For more information, see 'Fitch Affirms Brooklyn Union Gas & KeySpan Gas East's IDRs at 'BBB+'; Outlook Stable', dated 01 December 2020 at www.fitchratings.com.
Focus on US Asset Growth: Fitch expects US regulatory asset value (RAV) to grow faster than the UK in the medium term, achieving the higher end of the group's asset growth target of 5%-7%. UK's RAV and the US RAV grew 4% and 12% yoy, respectively in FY20 at constant currency. We expect the US regulated business will continue to drive overall revenue growth for the group.
Linkage between US Opco's and NG: In our rating approach for US opcos KEDNY and KEDLI whose IDRs are at 'BBB+', we recognise the benefit of ring-fencing measures including authorised regulatory capital structures, and dividend payment restrictions to allow for the rating to be above that of the parent. If NG's IDR is downgraded to 'BBB-', the US subsidiaries are unlikely to be constrained, as Fitch currently allows a two-notch rating differential.
UK Opco's Ratings Likely Constrained: In our rating approach for UK opcos NGET and NGG, we recognise the benefit of the regulatory ring-fencing and the parent's intention to keep the leverage at these entities within the regulatory guidance (60% from RIIO-T2) for the rating to be above that of the parent. However, we would not widen the rating differential between NG and its rated subsidiaries beyond two notches. The Negative Outlooks signals that NGET and NGG's ratings are likely to be constrained at 'BBB+' if NG's IDR is downgraded to 'BBB-'. Similarly, hybrid debt ratings would be notched down from the group's IDR.
Challenging UK RIIO-T2 DD: Ofgem announced in July 2020 its DDs for gas distribution networks (GDs), gas transmission networks (GTs) and electricity transmission networks (ETs) for RIIO-T2. The consultation period was open until September 2020, with FDs due in December 2020. The major changes from the sector-specific methodology decision published in 2019 include a 35bp decrease in real weighted average cost of capital (WACC) to 2.72% (including 25bp of generic Return on Regulatory Equity (RoRE) outperformance) from the previous proposal of 3.08% (which included 50bp of generic RoRE outperformance).
Rating Pressure on NG: The rating of NG could face further negative pressure should there be no substantial progress on the totex allowances between the DD and FD and no other remedial measures, such as a reduction to the scope of works. NG's FFO net leverage is above our current negative rating sensitivity and could be further affected by lower operational cash flow of NGET and NGG, which in turn could reduce the amount of cash flow available to NG for debt service.
Pandemic-Associated Cost Considerable: NG's 1HFY20 results published in November reiterated the group's guidance for FY21, a GBP400 million impact on operating profit and GBP1 billion cashflow hit, both related to the pandemic. NG expects to recover the majority of the COVID-19 impact over the medium term, but our rating case does not reflect this due to uncertainty about the timing and extent of the recovery.
RIIO-T2 PMICRs Considerably Weaker: We expect NGET's and NGG's average cash-based post-maintenance interest coverage (PMICR) to be materially weaker during RIIO-T2 than in the current regulatory period, but above our negative sensitivity of 1.7x and 1.9x, respectively. In our view, both companies are better-placed than other UK network operators under the same regulatory frameworks due to their ability to raise debt at lower interest rates and high proportion of index-linked debt.
UK Regulated Framework Supportive: We assess the regulatory environment of UK gas and electricity networks as transparent, predictable and independent given the regulator Ofgem's continued constructive, and challenging, engagement through consultation with stakeholders and price-control features that reduce risk. The next RIIO price control period will shorten to five years from eight currently, but will still be longer than in the US. Regulatory periods for NG's US distribution networks typically last up to three years, after which new rate cases need to be filed to ensure that all regulated assets earn allowed regulatory returns and all of the operating expenses are recovered through customer bills.
UK Versus US Regulatory Risks: RIIO regulation in the UK provides longer-term cash flow visibility than the US as most key regulatory variables are adjusted automatically. Notwithstanding NG's emerging record of timely rate case filings, regular re-filings carry associated equity return reset risk and hence shorter-term visibility on allowed returns than in the UK. Timely updated rate plans would allow appropriate cost recovery and rate-base recognition and hence improve the networks' ability to achieve allowed return on equity (ROE), although rate-case filings may not necessarily lead to higher allowed ROEs. In FY20, the US regulated business achieved a 9.3% ROE (8.8% in FY19) versus the 9.4% allowed level, which amounts to 99% of allowed returns (94% in FY19).
NG's Long-Term IDR is notched down once below the consolidated credit profile of 'BBB+' reflecting additional debt at the group level and structural subordination to opcos. NG's consolidated credit profile is comparable with other European transmission/system operators'. NG has marginally lower debt capacity than Terna S.p.A (BBB+/Stable) and Snam S.p.A (BBB+/Stable) reflecting the US's less mature regulatory frameworks from which NG generates an increasing share of income. Its lower debt capacity is mitigated by its scale and overall geographic and regulatory diversification. Despite higher leverage, NG's consolidated credit profile is on a par with Enagas S.A.'s (BBB+/Stable), reflecting the NG's scale and larger share of regulated business.
We consider other main European transmission system operators, such as Fingrid Oyj (A/Stable), Red Electrica Corporacion S.A. (A-/Stable), Amprion GmbH (BBB+/Stable) and Terna S.p.A. as NGET's main peers. We view the regulatory frameworks in the UK, Finland and Italy as mature and as NGET's leverage is higher than that of Fingrid and lower than that of Terna, this justifies the rating differentials between these peers. NGET's rating is higher than Amprion's despite the former's higher leverage, given the established record of the regulatory framework in the UK versus that of Germany under which Amprion operates.
We consider other western European gas transmission operators, such as Enagas S.A. in Spain and Snam in Italy as NGG's main peers. While NGG and Snam benefit from similarly mature and transparent regulatory frameworks with independent regulators, lower debt capacity is warranted for Enagas due to the emerging record of a truly independent regulator in Spain and Enagas' higher share of non-regulated earnings (over a third of total EBITDA). NGG's lower leverage justifies the one-notch rating differential with Snam's.
Fitch's Key Assumptions
NG's capex of about GBP23 billion in FY21-FY24
Average annual cash dividend of about GBP1.4 billion in FY21-FY24
NG's average cash cost of debt at about 3% per year in FY21-FY24
Foreign exchange rates: GBP/USD 1.15 for FY21-24
Restricted cash in FY21-FY25 assumed at the same level as in FY20 audited accounts (GBP37 million)
Cross-currency interest rate swaps out of the money (GBP86 million) and therefore increase net debt
Operating profit to reduce by about GBP400 million in relation to coronavirus pandemic, in FY21. The deferral of rate increases across New York, incremental COVID-19 related costs, and higher bad debt, are the most significant contributors to this decline. Recoveries are not modelled
US Business achieving slightly below 95% target for allowed ROE
Fitch Key Assumptions for RIIO-T1 and RIIO-T2
RPI of 1.6% in FY21, 2% in FY22, and 2.6% for FY23-FY26
CPIH of 2% on average from FY22-FY26
Allowed cost of debt at 1.1% in FY21 (real, RPI-linked)
Allowed cost of debt at 1.74% on average for FY22-FY26 (real, CPIH-linked)
Allowed cost of equity at 3.95% (CPIH-stripped) for FY22-FY26
25 bp outperformance included in ROE, in line with Ofgem's indications for FY22-FY26
No additional totex or incentive outperformance for FY22-FY26
Allowed weighted average cost of capital (WACC) at 2.75% in FY22 reducing to 2.53% by FY26 (real, CPIH-linked)
Factors that could, individually or collectively, lead to positive rating action/upgrade:
NG: The rating is on Negative Outlook; therefore, a positive rating action is unlikely in the short term. However, the Outlook could be revised to Stable if NG demonstrates a clear deleveraging path with FFO consolidated net leverage at or below 6.3x by FY23.
A revision of NG's Outlook to Stable will be replicated for NGET and NGG, provided there are no changes in parent and subsidiary linkage (PSL) between the companies.
NGET: An improvement in cash PMICR above 2.3x / nominal PMICR above 2.5x and a decline in RAV-based net leverage to below 55% on a sustained basis, would be positive for the rating, if accompanied by a positive rating action on NG.
NGG: An improvement in cash PMICR above 2.5x / nominal PMICR above 2.7x and a decline in RAV-based net leverage to below 50% on a sustained basis, would be positive for the rating, if accompanied by a positive rating action on NG.
NGGH: A positive rating action on NGG, accompanied by no material debt at NGGH, would be positive for the rating.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Increase in FFO consolidated net leverage to 6.3x or higher on a sustained basis or consolidated gearing towards 69%, the latter of which will complement our assessment of NG's debt capacity.
Decline in consolidated FFO interest coverage to below 3.5x.
Negative rating action on key opcos, which could trigger our reassessment of NG' rating.
Significant adverse regulatory developments, including RIIO-T2 methodology decisions or outcome of KEDNY/KEDLI and other US rate case filings.
NGET: Decline in cash PMICR to below 1.7x/ nominal PMICR below 2.0x and RAV-based net leverage increasing to over 67.5% on a sustained basis or a downgrade of NG.
NGG: Decline in cash PMICR to below 1.9x / nominal PMICR below 2.1x and RAV-based net leverage increasing to over 64% on a sustained basis or a downgrade of NG.
NGGH: A negative rating action on NGG or issue of a significant amount of debt by NGGH or a negative rating action on NG.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity: At FYE20, NG had about GBP 1.0 billion (after restricted cash) of cash or cash equivalents and GBP5.5 billion of undrawn facilities, which are available for at least the next two financial years. These combined liquidity sources including about GBP4.4 billion of new debt issued in the year to date (end-November 2020) are more than sufficient to cover GBP4 billion of short-term debt maturities and expected negative free cash flow (FCF) of about GBP3.7 billion.
SUMMARY OF FINANCIAL ADJUSTMENTS
Cash interest paid adjusted to include capitalised interest.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
ENTITY/DEBT RATING PRIOR
National Grid Gas Holdings Limited LT IDR A- Affirmed A-
British Transco International Finance BV
LT A Affirmed A
National Grid Electricity Transmission plc LT IDR A- Affirmed A-
ST IDR F2 Affirmed F2
LT A Affirmed A
NGG Finance Plc
LT BBB- Affirmed BBB-
National Grid Gas plc LT IDR A- Affirmed A-
ST IDR F2 Affirmed F2
LT A Affirmed A
ST F2 Affirmed F2
National Grid Plc LT IDR BBB Affirmed BBB
ST IDR F2 Affirmed F2
LT BBB+ Affirmed BBB+
VIEW ADDITIONAL RATING DETAILS
Additional information is available on www.fitchratings.com