R&I Rating Methodology by Sector Electricity December 20, 2013 R&I applies this rating methodology mainly to the ten general electricity utilities that account for the majority of Japan's electricity business based on electricity sales. The methodology is also applied to Electric Power Development Co., Ltd. (J-POWER) and The Japan Atomic Power Co. (JAPC), wholesale electricity utilities that sell wholesale electricity to the general electricity utilities. Power supply has the characteristic of a public service that is essential for people's daily lives and industrial activities, and is subject to regulation and protection based on the Electricity Business Act. The general electricity utilities have specified service areas within which they supply electricity to meet general demand. The ten general electricity utilities are Hokkaido Electric Power Co., Inc., Tohoku Electric Power Co., Inc., The Tokyo Electric Power Co., Inc. (TEPCO), Chubu Electric Power Co., Inc., Hokuriku Electric Power Co., The Kansai Electric Power Co., Inc., The Chugoku Electric Power Co., Inc., Shikoku Electric Power Co., Inc., Kyushu Electric Power Co., Inc. and The Okinawa Electric Power Co., Inc. (OEPC). In addition to wholesale electricity utilities, some firms, particularly those requiring a tremendous supply of power, such as iron and steel, chemical and pulp and paper manufacturers, also provide electricity to the general electricity utilities as a sideline. Such wholesale suppliers are referred to as IPP (Independent Power Producers). Specified-scale electricity utilities, which are referred to as Power Producers and Suppliers (PPSs), cater to a certain scale of demand that satisfies the requirements specified by an ordinance of the Ministry of Economy, Trade and Industry. PPSs use the electric lines of general electricity utilities to supply electricity they generate themselves, or surplus electricity from other companies, to consumers in the deregulated sector. Japan has a robust protection and regulatory framework based on an electricity business system that includes an integrated power generation and transmission system, regional monopolies in the regulated sector and a rate system built on the cost-plus pricing system. With the passage of amendments to the Electricity Business Act in November 2013, however, the present system is set to change dramatically, and competitive pressures are likely to grow. 1/13
I. Evaluation of Business Risk 1. View of industry risk Electricity is a vitally important source of energy. Consequently the electricity industry plays an important role in the government's energy policy. In the era prior to deregulation, the electricity industry enjoyed a monopoly in its service areas. Firms managed their business under a solid institutional framework, where rates were calculated using a cost-plus pricing system, and although electricity suppliers had high debt for capital investments to expand supply capacity, the certainty of investment recovery was extremely high. Beginning in 1995 and until quite recently, however, the government has amended the Electricity Business Act several times, and the scope of the deregulation in the retail division has gradually expanded. At the same time, laws have been enacted and mechanisms have been created to promote competition among businesses, which has pushed the market toward greater efficiency. Since TEPCO's Fukushima Daiichi Nuclear Power Station suffered a severe accident following the Great East Japan Earthquake in March 2011, public confidence in the safety of nuclear power fell precipitously. The compensation for damages in the event of a serious nuclear accident climbs to an imposing amount. While risks are to a certain extent reduced by the Act on Nuclear Damage Liability Facilitation Fund (Fund Act), it is necessary to ascertain how this entity will actually function, because TEPCO is the first company that the law has been applied to. Moreover, since the Nuclear Regulation Authority was formed in September 2012, the safety regulation hurdles have been raised significantly, which should have a negative impact on the nuclear capacity factor of the industry as a whole. R&I assesses the risk of a severe nuclear accident as follows: 1) Through evaluations of individual firm risk and financial risk, incorporate into the rating of a company that caused a severe nuclear accident the risk that the adverse effects from the accident will extend to its business base, revenues/expenditures and financial position. 2) Incorporate into the normal evaluation of industry risk the risk that, as a result of the severe nuclear accident, the electric power industry as a whole will see a decline in the capacity utilization rate at nuclear power plants, incur a new investment burden or face revisions to the electricity business system. 3) The obligation to pay compensation for damages if a nuclear plant suffers a severe accident is too large for an individual firm to handle on its own. Although the probability of a severe 2/13
accident occurring is extremely small, the risk cannot be ignored given its size. R&I will incorporate into the industry risk for electric companies the "risk that a company will be compelled to shoulder an enormous financial burden, including the obligation to pay compensation for damages, if a nuclear plant suffers a severe accident in the future," as a tail risk. In light of the tail risk and the factors explained below, R&I considers the industry risk of the electricity sector to be relatively low. When evaluating an electric company like OEPC that does not own nuclear power plants, R&I will adjust its evaluation based on the fact the company does not bear the risk in 3). (1) Market size, market growth potential and market volatility In terms of the electric lighting and electricity rate income of general electricity utilities, the size of the market is about 15 trillion yen. The industry relies on domestic demand, and demand for electricity is influenced by domestic factors such as the trend in population, the economic growth rate and plant location circumstances. While the pace of growth in demand had already slowed considerably because of economic maturation, Japan's declining birthrate and growing proportion of elderly and the hollowing out of domestic industry, demand has been further weakened by efforts to curb electricity consumption since the Great East Japan Earthquake. Because this awareness of saving electricity has become the norm, the rate of market growth is projected to remain at this low level in the future as well. While the demand for manufacturing use is affected to some degree by economic fluctuations, residential and commercial demand remains solid. Generally the customer base is extremely broad, and power demand on the whole is comparatively steady. Although the electricity business has been buffeted by changing government policies since TEPCO's nuclear accident, and stable operation of nuclear plants has become difficult, market volatility is relatively small. (2) Industry structure (competitive environment) The electricity business competes with other energy sources, such as city gas and petroleum products, in a variety of demand sectors, including for heating. The competition among energy alternatives is limited, however, partly because in many demand sectors it is difficult to flexibly replace electricity with other forms of energy. 3/13
Among the firms managing an electricity business, only the ten general electricity utilities authorized under Japan's Electricity Business Act supply electricity to general consumers and engage in the entire process of power generation, transmission and distribution. A tremendous amount of capital investment is required to construct and maintain the integrated power generation and transmission system to uniformly operate power generating equipment and transmission facilities, and the position of the general electricity utilities, which are nearly monopolies in their service areas, is firmly entrenched. On the other hand, however, general electricity utilities have a so-called "universal service" obligation and cannot refuse to supply electricity to customers in their service area without a well-founded reason. While deregulation had some impact, including the heightened downward pressure on electricity rates, the market share of PPSs has been extremely limited. Under such circumstances, the Electricity Business Act was partially amended in November 2013 in a move toward implementing changes such as "fully liberalizing entry into the retail market" in around 2016, and "further securing neutrality of the power transmission/distribution sector through legal structural separation" over 2018-2020, while verifying the effects during each phase. If realized, the result will be a radical change from the existing system. Although the present competitive environment is relaxed, the probability of competitive pressures rising is high. (3) Customer continuity and stability Among the parameters that influence customer continuity and stability in addition to the competition between electric utilities is the rivalry with alternative energy and alternative equipment including city gas and distributed power systems. In the competition between electricity companies, the continuity and stability of customers in the regulated sector that accounts for about 40% of demand have been legally ensured. Given the comparatively high rates per kilowatt hour, the demand in the regulated sector offers excellent profitability. While customer continuity and stability might be weakened if competitive pressure builds as the result of institutional reforms, including full deregulation of the retail segment, the proportion of total demand accounted for by demand attrition appears likely to remain limited for some time. In the competition with alternative energy sources such as city gas and distributed power systems, on the other hand, there is room for demand attrition that is unrelated to the electricity business system. As regards electricity for business use in particular, the diffusion of cogeneration equipment and distributed power systems is directly connected to the weakening of demand. In 4/13
contrast to this, there are still many instances in the residential market where gas demand is replaced with electricity use through the spread of all-electric homes and the electrification of various devices. Consequently, the impact of inter-energy competition on total electric power demand is limited. While the influence of institutional reforms cannot be overlooked, customer continuity and stability in the electric power industry remain high. (4) Capital and inventory investment cycles The amount of investment in power generation infrastructure can reach several hundred billion yen for a single nuclear reactor and tens of billions of yen per LNG thermal power plant, while distribution equipment is expensive as well, with the electrical wire network of the trunk line system also requiring tens of billions of yen. In the case of a nuclear plant, stringent regulatory criteria must be met, and the capital investment burden has become much greater than in the past. Electricity is difficult to store, making it necessary to always balance supply and demand, and electric utilities must maintain supply capacity on a scale sufficient to cover peak summer and winter demand. Each electric utility operates its power generation and transmission equipment in an integrated manner with the goal of stable supply, and maintains a certain amount of supply capacity margin. While the equipment electric utilities possess is technically mature and the risk of obsolescence is minimal, the investment burden is substantial, and fixed assets account for a large percentage of total assets. Although there is a burden for the cost of repairs and regular equipment inspections, equipment can in fact be used for periods beyond the statutory useful life, and the capital investment cycle is relatively long. (5) Protection, regulations and public aspects Because electric power is essential for economic activity and people's lives, maintaining stable supply is critically important. Any circumstances that would greatly disrupt the business base of the electric utilities positioned as the core of the system must be avoided. Protection, regulations and public aspects are considered to be strong. The protection and regulatory framework surrounding the electric power industry continues to evolve significantly, however. The key issues are as follows: 5/13
< Market entry regulations and rate regulations under the Electricity Business Act > Japan's government began partial deregulation of the retail segment in March 2000, and has abolished rate regulations in the deregulated segment. The scope of deregulation has been expanded gradually, reaching more than 60% of total demand since April 2005. In addition, in line with revision of the Electricity Business Act in November 2013, the Organization for Nationwide Coordination of Transmission Operators will be established around 2015 (1st phase). Furthermore, the government has drafted a policy under which the system will be revised gradually after 2016 as well, including measures to fully liberalize the electricity retail market (2nd phase) and measures to further secure neutrality of the power transmission/distribution sector and fully liberalize electricity rates (3rd phase). In the regulated segment, the regional monopolies of the ten general electricity utilities have been substantively continued, and the certainty of recovery of their capital investments ensured through rate calculations using the cost-plus pricing system. To raise their rates, however, they are required to obtain approval from the Minister of Economy, Trade and Industry through a process that includes statements of opinions at an open hearing and a screening by the Consumer Commission. For rate revision applications since FY2012, the cost-plus pricing system has been rigorously applied, including implementation of strict cost assessments. Moreover, the regulation of rates based on the cost-plus pricing system will likely be abolished through the full liberalization of retail rates during the third phase, contingent on conditions such as proper competitive relationships being assured. < Fuel cost adjustment system > Under the fuel cost adjustment system, rates are adjusted automatically every month according to fluctuations in fuel prices (import prices for crude oil, liquefied natural gas and coal) in order to promptly reflect changes in crude oil prices and exchange rates in electricity rates. This system has allowed power companies to pass such changes on to rates comparatively quickly. Nevertheless, they might incur costs that cannot be adjusted using this system, when there is a major change in the cost structure as a result of, for example, the power generation mix being altered because of a long-term operational shutdown of nuclear plants. 6/13
< Statutory security concerning nuclear accidents > According to the Act on Compensation for Nuclear Damage (Nuclear Compensation Act), as a rule a nuclear power operator will assume full responsibility, except for the claim payment based on a contract of liability insurance for nuclear damage (up to 120 billion yen per nuclear plant), when a loss is caused by a nuclear power plant accident. As a provision when the amount that should be compensated exceeds the amount of the above-mentioned compensation measure, the Fund Act was enacted to implement compensation promptly and ensure the stable supply of electric power. With the financial assistance framework in this act serving as support, there is little concern that a utility's operations would quickly grind to a halt because of onerous claims. However, electric power companies will need to pay the Nuclear Damage Liability Facilitation Fund (Fund) a special contribution annually, using their disposable profit. A lengthy period of time is required to decide upon the damage compensation amount, and the total special contribution payments will climb as the scale of compensation for damages grows in size. This legal framework makes it difficult for a nuclear power operator that causes a serious accident to chart a path toward financial stability. < Safety regulations from the Nuclear Regulation Authority > The Nuclear Regulation Authority launched in September 2012 has established exacting regulatory standards, including the application of the latest rules to existing nuclear power plants. These new criteria have elevated business risk by compelling nuclear power operators to undertake capital investment to fulfill the new standards, for example, and making it more difficult than in the past to ensure stable operations. (6) Cost structure Thanks to the cost-plus pricing system, the regulated segment ensures a high degree of revenues and expenditures stability. Over the medium to long-term, there is a possibility this stability will be weakened through institutional reforms. The industry is capital-intensive, and has a heavy fixed cost burden for items such as depreciation and amortization expense. While the fuel cost adjustment system acts as a critical support for variations in fuel costs, revenues and expenditures come under considerable pressure when a nuclear power plant is shut down for the long-term and the fuel cost for alternative power balloons, because cost is calculated based on a certain power generation mix. 7/13
(7) Risk of compensation for damages as the consequence of a severe nuclear plant accident As demonstrated by the accident at TEPCO's Fukushima Dai-ichi Nuclear Power Plant, a large release of radioactive materials leads to extensive nuclear damage and also results in tremendous costs in the form of compensation for damages. Enormous outlays are also required for the post-accident cleanup and decommissioning of a heavily damaged nuclear reactor. While the probability of a serious accident at a nuclear plant is extremely low, a nuclear power plant operator will suffer devastating damage it cannot address on its own if a severe accident has occurred. R&I views this to be a unique tail risk of the electric power industry. Unless the central government devises drastic measures by, for example, revising the Nuclear Compensation Act to assume a sufficient role in damage compensation, this tail risk cannot be easily mitigated. 2. View of individual firm risk R&I substantially reflects industry risk in its rating evaluations with an emphasis on the electricity business system framework, whereas the weight of individual firm risk is relatively small. As the revision of the traditional institutional framework progresses, however, R&I will emphasize the evaluation of individual firm risk. (1) Scale and stability of demand in operating area Electric power is a typical capital-intensive industry, with benefits of scale easy to achieve from a capital equipment and fuel procurement aspect, and the volume of demand in a firm's service area is a vital factor. Capital investment efficiency is influenced by the level of demand density as well. The stability of demand is determined by factors such as the demand structure, population dynamics and the growth rate in demand based on economic conditions within the supply area. The demand structure can be understood through the percentage of demand for manufacturing use and commercial/household use, and by a further breakdown of each category. Manufacturing use demand is susceptible mainly to economic and factory location trends. Commercial and household use demand, although not projected to grow significantly, is comparatively stable. Historically, differences in the demand structure, for example, did not result in varying demand stability. In the future, however, differences among service areas in terms of competitive pressure, the energy situation and level of electricity rates that arise in conjunction with the progress in institutional reform could affect the stability of demand. 8/13
(2) Power generation mix Energy sources for power generation include hydroelectric power, thermal power (coal, oil and LNG), nuclear power and other sources (solar, wind power, geothermal heat, etc.). It is efficient to use nuclear power, coal-fired thermal power and LNG thermal power as the base power supply and supplement this through use of hydroelectric power or oil-fired thermal power during peak daytime hours when power demand increases. Nuclear power generation is superior from the perspective of power generation cost when operations are stable, but can exert a negative influence on profits and cash flow when operations are halted for an extended period of time because of an accident or other reason. With the tightening of safety regulations, the medium to long-term outlook for nuclear capacity factor is uncertain. Payment of contributions under the Fund Act and investments in safety measures will become factors putting pressure on revenues and expenditures and companies' financial profiles. While the ideal approach to the power generation mix will change as a result of the government's energy policy, having a certain percentage of hydroelectric power or thermal power generation capacity available and a power generation mix with sufficient resilience to withstand an unexpected nuclear power shutdown will support a strong positive evaluation. (3) Strength of competitive pressures and management efficiency For the electric power industry, which is supported by a regulatory and protection framework, competitive pressures are limited compared to those faced by other general operating companies. The strength of competitive pressures, however, exhibits some variation based on factors such as demand density, industry concentration and geographic conditions in a company's service area. If a competitive environment is established as a result of the reform of the institutional framework, competitive pressures may increase across the industry. Because ensuring low rate levels becomes a critical issue, management efficiency will become an important topic as well. In addition to the characteristics that arise from the geographic characteristics of a company's service area, R&I will look closely at the cost competitiveness resulting from such qualities. (4) Ratio of inter-company power sales Anticipating future growth of electricity demand, electric companies develop a certain scale of power sources. Because investment efficiency of small-scale power sources is lower, however, they develop large-scale power sources that exceed the capacity required in their service area and sometimes enter agreements to sell electric power to nearby electric companies for a certain period 9/13
of time. If the growth in demand in a company's service area is gradual, and there are significant sales of electric power between regions, there is a possibility an electric company will have surplus power sources, a situation that is undesirable from the standpoint of recovery of its investment. II. Evaluation of Financial Risk In addition to quantitative factors in the form of financial data, R&I also evaluates qualitative factors, such as a firm's financial management policy and liquidity risk, in its analysis of financial risk. For the electricity industry, R&I emphasizes the following financial indicators based on the industry's business characteristics. (1) Earning capacity Return on Assets (ROA), EBITDA (earnings before interest, taxes, depreciation and amortization)/average total assets Because the length of the investment recovery period will depend on whether the company is obtaining profits and cash flow efficiently from its assets, R&I focuses on ROA and EBITDA/average total assets. While the ratio of EBITDA to average total assets is ensured at a certain level, reflecting the capital intensive nature of the business, electricity is also a regulated industry in which excessive profits are controlled, and the ROA is lower than in other industries. Although this reflects various parameters such as demand density, the equipment load factor and the power generation mix, a decline in the nuclear capacity factor can easily result in deterioration of this indicator. For a small electric company, not only will the increase in total assets during development of a large-scale power supply be conspicuous, the depreciation burden immediately following the start of operations will be substantial, putting a limit on the numerical value. (2) Scale and investment capacity EBITDA, equity capital The electricity business is a typical capital intensive business, and investments for new facilities and upgrades within any given period are indispensable for stable supply. EBITDA is critical for examining whether a company is capable of ensuring cash flow on a scale that will enable it to support investments, including large-scale power generating stations. Even small-scale electric companies require comparatively large-scale power generating stations to maintain competitiveness, and during the construction of such facilities, deterioration in a small utility's 10/13
debt-equity structure will be relatively serious. Because electricity is a process industry with a heavy capital investment burden, the amount of equity capital, as well as an ability to generate cash flow, is important for judging scale and investment capacity. (3) Debt redemption period Net debt to EBITDA ratio For examining whether a company can recover its investment within a certain timeframe when the funds invested in its electricity business are raised mainly through debt, R&I considers it important to look at how many times EBITDA exceeds the amount of net debt. The practical life of key facilities for hydroelectric and thermal power generation and in the power transmission/distribution sectors can reach considerably long periods. Under the new regulatory criteria, a 40-year operating restriction has been established for nuclear plants. An operational period will be restricted more strictly than in past years, while this depends on how the criteria will be applied. Although electricity is an industry that can anticipate comparatively stable earnings, should nuclear power-related capital investments in areas such as safety measures climb substantially, or rising competitive pressures reduce the ability to generate cash flow, this will affect the debt redemption period. (4) Financial profile Equity ratio, net D/E ratio (ratio of net debt to equity capital) From the standpoint of financial resilience, R&I puts special emphasis on the equity ratio and the net D/E ratio. Compared with the past, the importance of the financial profile has increased in light of elevated business risks, including the tail risk of a severe nuclear power accident and the tightening of nuclear power regulations. 11/13
III. Rating for Electricity Industry Issuer Rating Individual Firm Risk Financial Risk Importance Indicator Importance Scale and stability of demand in operating area Return on Assets (ROA) Earning capacity Power generation mix EBITDA/average total assets Strength of competitive pressures and Scale and investment EBITDA management efficiency capacity Equity capital Ratio of inter-company power sales Debt redemption period Net debt to EBITDA ratio Equity ratio Financial profile Net D/E ratio Industry Risk: Relatively low Note) Importance is indicated by : extremely important, : important, or relatively important. Factors considered when rating wholesale electricity utilities For the wholesale electricity utilities, whose main business is selling power to general electricity utilities, each firm's earning capacity and ability to generate cash flow are influenced by the specifics of its wholesale contracts and the demand trends at its customers. The facilities owned, including the power generation mix, have distinct characteristics as well. When evaluating the wholesale electricity utilities' creditworthiness, R&I focuses on the details of sales agreements, supply and demand characteristics, and the demand trends at customers. Because they invariably are influenced by the financial health of the general electricity utilities they depend on for the bulk of their sales, R&I takes the level of creditworthiness of general electricity utilities into consideration as well. The effect of electric power system reforms, including the abolition of wholesale regulations and revitalization of the wholesale electricity market, also cannot be overlooked. 12/13
* This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 13/13