Credit Opinion: Latvenergo AS

Transcription

1 Credit Opinion: Latvenergo AS Global Credit Research - 17 Feb 2015 Riga, Latvia Ratings Category Outlook Issuer Rating Moody's Rating Stable 2 Contacts Analyst Phone Raffaella Altamura/London Niel Bisset/London Andrew Blease/London Key Indicators [1]Latvenergo AS 12/31/ /31/ /31/2011 (CFO Pre-W/C + Interest) / Interest 12.2x 10.9x 11.5x (CFO Pre-W/C) / Net Debt 35.0% 34.4% 41.1% RCF / Net Debt 30.5% 25.2% 32.6% (CFO Pre-W/C) / Debt 25.5% 24.7% 32.5% RCF / Debt 22.2% 18.1% 25.8% [1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non- Financial Corporations. Source: Moody's Financial Metrics Note: For definitions of Moody's most common ratio terms please see the accompanying User's Guide. Opinion Rating Drivers - Dominant position in Latvia but relatively small size and short position in generation leave the company vulnerable to changes in the electricity markets - Cash flows are exposed to variable hydrogeneration while gas-fuelled plants are reliant on capacity payments - Supply market opening presents risks and opportunities - Regulated network activities add a degree of predictability to cash flows but tariff implementation lacks transparency and consistency - Government support provides two notches of rating uplift Corporate Profile

2 Latvenergo AS (2 stable) is the dominant, vertically integrated utility in Latvia, with total installed electricity generation capacity of 2.6 gigawatts (GW), representing approximately 85% of the total Latvian capacity. Latvenergo's main power plants comprise three hydro-power plants on the River Daugava and two combined heat and power plants in Riga. In addition, the group owns the country's electricity transmission grid assets (operated by an independent system operator) and owns and operates the electricity distribution network. Latvenergo is 100% owned by the Government of Latvia. SUMMARY RATING RATIONALE Latvenergo's 2 rating is underpinned by (1) the group's strong competitive position in its Latvian domestic market as a vertically integrated utility; (2) the high proportion of its cost competitive and environmentally clean hydro generation base; and (3) the contribution from regulated transmission and distribution activities, which support the stability of the company's cash flow. However, Latvenergo's rating is constrained by (1) its small size; (2) the group's substantial short generation position vs. its supply requirements; (3) the low competitiveness of its gas-fuelled combined heat and power plants and their current reliance on a guaranteed support scheme which has decreased over time; (4) the evolving nature of the electricity markets in which Latvenergo operates, which could exert downward pressure on the group's profitability and negatively impact its competitive position; and (5) the lack of consistent application of regulation and the political interference related to tariffs applied with respect to its regulated network activities. Latvenergo's rating of 2 incorporates two notches of uplift for potential extraordinary support from the Government of Latvia (A3 stable), the 100% owner of Latvenergo. DETAILED RATING CONSIDERATIONS DOMINANT POSITION IN LATVIA BUT RELATIVELY SMALL SIZE AND SHORT POSITION IN GENERATION LEAVE THE COMPANY VULNERABLE TO CHANGES IN THE ELECTRICITY MARKETS Latvenergo is the dominant utility in Latvia. Its installed electricity generation capacity totals 2.6 GW (approximately 85% of the country's total), of which 1.5 GW (60%) is represented by hydro power plants (HPPs) and the remainder by gas-fuelled plants. Despite its strong position in the Latvian market, the company's scale remains fairly small in the European context, which leaves the company exposed and more vulnerable to changes in the electricity markets. The group generated 2.7 TWh of electricity in the nine months to September 2014 (vs. 3.8 TWh in the corresponding period in 2013), which accounted for approximately 40% of the electricity supplied in the same period (6.5 TWh). Latvenergo covers the supply shortfall by mandatory procurements from other small Latvian generators and imports from the Nord Pool Spot electricity exchange. Whilst Latvenergo uses its physical asset base and derivative financial instruments to mitigate its power price exposure, its substantial short position weighs negatively on our risk assessment of the group. CASH FLOWS ARE EXPOSED TO VARIABLE HYDROGENERATION WHILE GAS-FUELLED PLANTS ARE RELIANT ON CAPACITY PAYMENTS The average annual production of Latvenergo's HPPs is around 2.8 TWh, which is approximately 40% of the total annual electricity demand in Latvia (around 7 TWh). During the spring flood period, which typically lasts one to two months, the generation output significantly exceeds the domestic demand, thus supporting electricity exports (mainly to Lithuania). However, the nature of this generation base exposes Latvenergo to high volatility, which can significantly impact the company's financial performance. For example, for the nine months to September 2014, Latvenergo's HHPs generated 1.6 TWh of electricity, which was 33% lower than the level of power generated in the corresponding period in These exceptionally dry conditions resulted in a significant reduction of volumes available to cover supply needs and exports, while at the same time materially increasing electricity import needs. In light of these factors, Latvenergo's EBITDA generated by the supply and generation segment decreased by approximately 27% (to EUR66 million) for the nine months to September 2014 (vs. the corresponding period in 2013). On the other hand, Latvenergo's combined heat and power plants (CHPs) run mainly on natural gas and their competitiveness has been negatively impacted by the relatively high gas prices and the progressive decrease of wholesale electricity prices in the Nord Pool area, on the back of strong hydro production and weak domestic demand in the Nordic countries. Historically, Latvenergo's CHPs have benefited from a guaranteed support scheme. However, in January 2014, fixed capacity payments were reduced and the compensation for the

3 difference between the plant operating costs and the costs recovered through sales at the market price was discontinued. In addition, a 15% tax rate was introduced on the fixed capacity payments received for gas-fuelled cogeneration plants. The changes to the support mechanisms described above and the additional fiscal measures imposed in respect of CHP generation are negative for Latvenergo, as they impact the profitability of these assets. Whilst Latvenergo has some flexibility to vary its CHP output, there is some residual risk that it would still have to pay the costs of procuring gas under its take or pay contracts. In addition, any scale backs in respect of generated power would result in increased needs for electricity imports and consequent exposure to power price volatility. More generally, we note that Latvenergo's generation base is relatively clean, given the contribution of hydro sources and the relatively modest CO2 emission levels associated with its gas-fuelled power plants. As a result, the company benefits from relatively low exposure to potential CO2 price increases and related impact on margins and asset competitiveness. SUPPLY MARKET OPENING PRESENTS RISKS AND OPPORTUNITIES The Latvian electricity market is undergoing substantial changes. The liberalisation of the country's electricity supply segment was finalised in January In our view this creates opportunities for Latvenergo, as it is expected to result in the implementation of a market-reflective tariff and the gradual correction of the historical electricity supply tariff shortfalls characterising residential accounts. Households customers in Latvia account for around 25% of Latvenergo's total supply volumes and, in the nine months to September 2014, the application of capped residential tariffs resulted in lost revenues of approximately EUR38 million for the company. However, at the same time, the full liberalisation of the Latvian electricity market will create an opportunity for new entrants, thus potentially impacting Latvenergo's current dominant market share in the country's electricity supply segment. While we do not anticipate a sudden change in the supply market, a deteriorating trend would negatively impact Latvenergo's credit quality over time. More generally, this factor, coupled with the expectation of decreasing power prices in the Baltic region due to increasing interconnection and physical integration with the Nordic market, weigh on the company's credit quality. REGULATED NETWORK ACTIVITIES ADD A DEGREE OF PREDICTABILITY TO CASH FLOWS BUT TARIFF IMPLEMENTATION LACKS TRANSPARENCY AND CONSISTENCY Latvenergo owns the Latvian electricity transmission grid assets, which are however operated by an independent transmission system operator, with the company earning a regulated lease fee on these assets. Latvenergo also owns and operates the country's electricity distribution network. Regulated transmission and distribution operations accounted for approximately 55% of group EBITDA in the nine months to September 2014, which support cash flow stability. However, we estimate that going forward this contribution will decrease slightly, mainly on the back of improving margins associated with the full liberalisation of the Latvian market. The energy markets in Latvia are regulated by the Public Utilities Commission. We consider the Latvian regulatory framework to be relatively new and less transparent compared to more developed and established regulatory regimes in Europe. We acknowledge the relative supportiveness of the regulatory environment, but we also note the political considerations surrounding actual methodology application. The political interference in the company's ability to charge tariffs according to regulatory principles and the associated impact on full cost recovery act as a constraint on Latvenergo's credit quality. GOVERNMENT SUPPORT PROVIDES TWO NOTCHES OF RATING UPLIFT Latvenergo's 2 rating incorporates an uplift for potential government support to its standalone credit quality. We express this as a Baseline Credit Assessment (BCA) of ba1. The uplift to the BCA, of two notches, is a result of the credit quality of the Government of Latvia (A3 stable), which owns 100% of Latvenergo's shares, as well as our assessment of there being a high probability of government support for the group in the event of financial distress, and a high level of default dependence (i.e. degree of exposure to common drivers of credit quality). Liquidity Latvenergo's liquidity profile has strengthened in recent months. As of 30 September 2014, Latvenergo reported EUR163 million of cash and cash equivalents. In addition, at the end of 2014, the company finalised additional bank loans of cumulatively EUR320 million, which support investment requirements and refinancing needs.

4 Overall, we expect that available resources and generated cash will be sufficient to cover Latvenergo's needs for a period in excess of at least 18 months. We note however that Latvenergo does not maintain additional committed liquidity facilities. Historically, Latvenergo increased the diversification of its debt structure through the issuance of bonds in a total amount of just over EUR100 million. However, the company is still heavily reliant on bank financing, although from a diversified mix of banks, and primarily represented by term loans with a scheduled amortisation profile. Latvenergo has historically fulfilled all applicable financial covenants under its debt terms. Whilst we expect the company to manage its financial profile in line with covenant requirements, we caution that the headroom under its debt service coverage ratio (DSCR) covenant and the net debt to EBITDA covenant is relatively limited over the next months. Latvenergo's capital expenditure programme is expected to continue to absorb the company's cash flow, although we note the flexibility associated with the finalisation of specific capex projects. Total planned investments total approximately EUR1 billion over the period The maintenance of the electricity networks is expected to account for around 70% of planned capital expenditure over the period. In the generation segment, the main single project is the HPPs reconstruction programme, which has an estimated spending of some EUR200 million up to Further investments in generation assets may also be considered. Rating Outlook The outlook on Latvenergo's rating is stable, reflecting our expectation that, in the context of the risks and opportunities characterising the evolving Latvian market, the company will be able to maintain a financial profile generally in line with the current guidance. What Could Change the Rating - Up Upward rating pressure could develop if (1) Latvenergo's credit metrics were materially stronger than currently anticipated; (2) the ongoing market transition and regulatory developments in Latvia settle in Latvenergo's favour and/or (3) the credit quality of the Government of Latvia were to materially strengthen. However, in light of the ongoing developments characterising the Latvian electricity market and the stable positioning of the Latvian Government rating, positive rating pressure is not expected to materialise over the short term. What Could Change the Rating - Down Latvenergo's rating could come under downward pressure if (1) the company were not able to maintain a financial profile commensurate with the current guidance (i.e. Funds From Operations (FFO) / debt ratio declining below 20% and FFO interest coverage ratio falling below 5.0x on a sustained basis); (2) the liquidity profile of the company were to deteriorate; (3) there were material adverse changes in the regulatory or legal frameworks in Latvia; and/or (4) the credit quality of the Government of Latvia and/or the support assumptions currently incorporated into our assessment were to weaken. Other Considerations The principal methodologies used in rating Latvenergo are Moody's "Unregulated Utilities and Power Companies", published in November 2014 and "Government Related Issuers", published in October Please see the Credit Policy page on for a copy of these methodologies. Rating Factors Latvenergo AS Unregulated Utilities and Unregulated Power As of 31 [3]Moody's Month Companies Industry Grid [1][2] December 2013 Forward ViewAs of 16/02/2015 Factor 1 : Scale (10%) Measure Score Measure Score a) Scale (USD Billion) Ba Ba Factor 2 : Business Profile (40%) a) Market Diversification Ba Ba b) Hedging and Integration Impact on Cash Ba Ba

5 Flow Predictability c) Market Framework & Positioning Ba Ba d) Capital Requirements and Operational Performance e) Business Mix Impact on Cash Flow Predictability Factor 3 : Financial Policy (10%) a) Financial Policy Factor 4 : Leverage and Coverage (40%) a) (CFO Pre-W/C + Interest) / Interest (3 11.5x A 9-10x A Year Avg) b) (CFO Pre-W/C) / Net Debt (3 Year Avg) 36.7% A 28-32% c) RCF / Net Debt (3 Year Avg) 29.4% A 25-28% A Rating: a) Indicated Rating from Grid 2 2 b) Actual BCA Assigned ba1 Government-Related Issuer Factor a) Baseline Credit Assessment ba1 b) Government Local Currency Rating A3 c) Default Dependence High d) Support High e) Final Rating Outcome 2 [1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non- Financial Corporations. [2] As of 31/12/2013; Source: Moody's Financial Metrics [3] This represents Moody's forward view; not the view of the issuer; and unless noted in the text, does not incorporate significant acquisitions and divestitures This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history Moody's Corporation, Moody's Investors Service, Inc., Moody's Analytics, Inc. and/or their licensors and affiliates (collectively, "MOODY'S"). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. ("MIS") AND ITS AFFILIATES ARE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODY'S ("MOODY'S PUBLICATION") MAY INCLUDE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY'S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY

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