OREANDA-NEWS. Fitch Ratings has affirmed Bazalgette Tunnel Limited's (Bazalgette; the company) GBP1bn revolving credit facility (RCF) and Bazalgette Finance plc's (Finco; the issuer) GBP10bn euro medium-term notes (EMTN) programme and bonds issued under it at 'BBB+' with Stable Outlook.

The ratings reflect the substantial protection afforded to the construction of the Thames Tideway Tunnel (TTT, the project) by a supportive, transparent and largely proven regulatory regime and strong support commitments from the UK government against completion and funding risk during construction. Furthermore, the ratings reflect the experience of the parties involved in the project's construction, achievable cost and schedule targets, and Fitch's view that once it is commissioned, the project's operational risk profile will be low.

Financial metrics for 2017-2035 under Fitch's base case are strong (average/median/minimum Fitch adjusted PMICR of 3.83x/2.92x/2.70x) thanks to reasonably conservative leverage targets of 65%. The limited visibility of the future regulatory environment resulting from the length of construction period precludes the project from achieving a higher rating, despite the solid financial coverage.

KEY RATING DRIVERS

Completion Risk - Midrange

During the first year since licence award, TTT has been progressing with pre-construction works and proactively managing consents and permits approval. The process is ahead of schedule. The company and the contractors also reviewed and optimised the construction works' plan which foresees project handover ahead of schedule. Fitch views positively the shorter schedule as this will allow greater contingency to deal with construction issues as they arise.

The project's construction is inherently complex and lengthy. However, in Fitch's opinion, completion risk is well managed and mitigated thanks to the project's detailed planning, the involvement of several experienced contractors and personnel, a supportive regulatory framework under Ofwat's supervision and a strong support package from the UK government, which aims at providing liquidity and additional equity should severe stress scenarios materialise. Consequently, completion risk does not constrain the rating.

Revenue Risk - Stronger

The revenue structure is based on the well-established approach used for the UK water sector and regulated by Ofwat, subject to the adjustments for the construction period. The issuer will not be exposed to volume risk, but will have exposure to tariff risk every five years during operations. The company earns a return on capital on its regulated capital value (RCV) and is able to recover depreciation, tax and allowable opex. The RCV will increase with inflation.

Ofwat will determine the weighted average cost of capital (WACC) and opex every five years during operation (real WACC is fixed at 2.497% during construction). WACC will be the main revenue driver. In Fitch's opinion, the regulator's discretion over the company's key revenue driver is lower than the sector average, given the limited operating and capital requirement post construction.

Ofwat's recent statement regarding the continued indexation to RPI of the project company's RCV until 2030 confirms the regulator's transparent and consistent adherence to the project's licence in the context of the wider changes currently under discussion for the UK water sector from 2020.

Operational Risk - Stronger

The project has very low operating risk, as the tunnel uses proven technology, relies on gravity to transfer sewage and essentially has no moving parts. After system acceptance, the main operating responsibilities of the project company are 10-year reviews of the tunnel condition.

Infrastructure Development and Renewal - Stronger

Once completed, the assets will essentially have no moving parts and an economic life of 120 years. It is not expected that there will be significant need for major refurbishment for at least the first 10 years.

Debt Structure - Stronger

The debt structure factor reflects our assessment of Bazalgette's consolidated future debt, which comprises the RCF, the EMTN programme (together with associated intra-company loans) and a GBP700m European Investment Bank (EIB) loan facility, for a total current undrawn available commitment of GBP2,050m. According to the company's funding plan, the debt will be drawn from 2018 upon depletion of the GBP1.274bn provided by equity holders. The company's management maintains a net debt to adjusted RCV target of 65%.

All Bazalgette debt is senior ranking, pari passu and supported by a comprehensive suite of covenants including leverage, hedging and distribution and maturity concentration controls.

The company has already proven its ability to access capital markets through the recent successful issuance of GBP350m delayed-draw, index-linked bonds. Market access risk during construction is comprehensively mitigated by several features, such as the receipt of revenues as construction works progress, the covenants requiring capex and debt service liquidity covering 12 months, committed liquidity support from the government in the event of debt market disruption during construction and, upon commencement of operation, WACC adjustment for changes in debt costs during construction. Ongoing refinancing risk is further mitigated by covenants limiting maturity concentrations and constraining maximum leverage to 70% of RCV.

Equity injection risk is adequately mitigated by the sponsors being leading infrastructure investors who will be contractually committed to fund equity up to the threshold outturn. All equity commitments are backed by letters of credit issued by 'A-' rated financial institutions. Equity will be fully drawn prior to any debt issuance.

Debt Service

During the construction phase, the project's cash flows will not be negatively impacted by cost overruns, increased cost of debt or lower inflation assumptions due to protective mechanism embedded in project's debt structure. However, during the operational phase, compression of cash flows available for debt service may occur if Fitch's current assumptions do not materialise.

Under Fitch's base case, the project demonstrates strong coverage metrics during 2017-2035 with average, median and minimum Fitch-calculated PMICR of 3.83x, 2.92x and 2.70x, respectively. The average is inflated by extremely high values for years at the beginning of the construction period.

Peer Analysis

The debt's financial metrics and leverage target are robust compared to corporate water utility metric threshold guidance and other secured financings such as Anglian Water and Yorkshire Water, which are rated at 'A', two notches higher than Bazalgette. However, these companies are not exposed to major capex projects with complexity similar to that of TTT. The rating is also constrained by the limited visibility on the future regulatory environment resulting from the length of construction.

RATING SENSITIVITIES

Negative rating action may result from:

- Major construction issues jeopardising the adequacy of the existing government support.

- Materially adverse regulatory changes that may affect the company's cash flow generation.

The scope for positive rating action is currently limited.

SUMMARY OF CREDIT

The company's business is to design, build, commission and maintain the TTT, the UK's largest sewer system improvement.