Down town

European utilities will continue to feel downwards pressure from credit rating agencies in the years ahead, as Fitch's Arkadiusz Wicik explains

Many European utilities entered the economic crisis with relatively high financial leverage, often the result of acquisitions and large capital expenditure (capex) programmes. The five largest European utilities rated by Fitch (EDF, Enel, Eon, Iberdrola and RWE) have been downgraded by an average of 2.2 rating notches since 2007, with the average credit rating for this group moving down to A- from A+ during the period.

Most of the downgrades have been for sector or country-specific reasons such as weaker demand and margins, and also unfavourable changes in regulation, energy policy or taxation. There were also company-specific reasons, such as higher debt after acquisitions.

We believe many European utilities still face downward rating pressure or, at best, have limited financial headroom at their current credit rating level. Of the big five, Enel and Iberdrola have a negative rather than stable rating outlook.

European utilities face many challenges, and this underpins Fitch’s negative outlook for German, Italian, Iberian and Nordic utilities. Operating cash flows will be under pressure in 2013 and 2014. This is because the prolonged economic contraction in much of Europe (we expect the eurozone’s GDP to contract 0.5 per cent in 2013, partly the result of a negative carry-over effect from last year) will lead to weakening demand and wholesale power prices, regulatory pressures and extra taxes for utilities in many European countries.

Crucially, the sector also faces a key structural challenge as companies try to offset lower cash flows from their conventional power plants as subsidised renewable generation takes a greater share. Generators with a bias towards thermal (especially gas) technologies are at greatest risk, particularly those in countries with a strongly rising contribution from renewable sources (Iberia, Germany, Italy) that are being pushed out of the merit order because of the priority dispatch for renewables.

This leads to overcapacity and reduces conventional power plants’ utilisation rates and wholesale power prices at a time of already weak demand for power, which leads to cash flow erosion. For example, forward wholesale power prices in Germany, Europe’s most liquid power market, have gradually decreased from a peak of close to €100/MWh (£86/MWh) in 2008 to about €40/MWh in recent weeks.

Utility managements’ reaction to the sector and macroeconomic challenges has been prudent, ranging from capex cuts (although most companies still have large capex plans), to asset disposals, cost cutting and efficiency improvements. Most plan to reduce debt and improve credit metrics in 2013-14. Several companies – including EDF, RWE and Iberdrola – have issued hybrid bonds in an attempt to strengthen their balance sheets. These bonds have a part-equity component, so they do not increase balance sheet leverage to the same extent as regular bonds. Also, we believe that the solid financial liquidity and good access to debt markets that large utilities have demonstrated are factors that mitigate some sector and macroeconomic challenges.

Arkadiusz Wicik is senior director of Fitch Ratings

Ratings roll call

EDF (A+): is under less pressure from the operating environment in its home market than the other big four utilities we rate here. This is because of the less pronounced structural changes in France to date and EDF’s focus on nuclear power, which contributes to more predictable cash flows compared with its peers.

Enel and Iberdrola (both BBB+/Negative): the difficult operating environment and macroeconomic and regulatory pressures are among the reasons for these companies’ negative rating outlooks. However, although they are in the more challenged southern Europe periphery, the ratings of Enel and Iberdrola are not constrained by the sovereign ratings of Italy (BBB+/Negative) and Spain (BBB/Negative) respectively. It is also worth noting that both Enel and Iberdrola have a strong degree of geographical diversification.

Eon (A) and RWE (A-): both companies have stable rating outlooks despite the negative outlook for the German utilities sector. The challenges here are mitigated by the companies’ financial strategies to improve their credit ratios in the medium term, before the period of large cash outlays for nuclear decommissioning. The stable outlooks reflect Fitch’s assumption that there will be substantial progress in the implementation of credit-preserving measures.

“Regulated” interests: Fitch expects the regulated business (networks) and quasi-regulated business (subsidised renewables in transparent regulatory frameworks without onerous fiscal pressures) to be stabilising factors for the utilities’ overall earnings before interest, taxes, depreciation and amortisation (Ebitda). Iberdrola and Enel generate more than 60 per cent of Ebitda from these segments, while RWE and EDF only generate about 30 per cent in this way.

This article first appeared in Utility Week’s print edition of 26th April March 2013.

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