OREANDA-NEWS. Fitch Ratings has affirmed Zhejiang Provincial Energy Group Company Ltd's (ZEG) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'A'. The Outlook is Stable.

Fitch has also affirmed the rating of the US dollar senior unsecured notes issued by Zhejiang Energy Group (Hong Kong) Limited (ZEHK) at 'A'. In place of a guarantee, ZEG has granted a keepwell, liquidity support and equity interest purchase covenants deed to ensure ZEHK has sufficient assets and liquidity to meet its obligations under the US dollar notes.

ZEG is 100% owned by the State-Owned Assets Supervision and Administration Commission of the People's Government of Zhejiang Province (Zhejiang SASAC). ZEG's ratings are aligned with the credit profile of the Zhejiang provincial government due to strong operational and strategic linkages between ZEG and Zhejiang SASAC.

KEY RATING DRIVERS

Linkage with Zhejiang Province: ZEG is the sole state-owned energy production and investment vehicle under the direct supervision of Zhejiang SASAC. ZEG's key strategic mandate is to ensure sufficient and stable energy supply for Zhejiang province, accounting for around half of the province's on-grid thermal power capacity at end-2015. In addition, ZEG is the Zhejiang's monopoly midstream natural gas distributor and its largest coal trader. ZEG has regularly received government support, including government-administered zero-cost asset transfers, grants and subsidies.

Resilient Power Generation Operation: Power oversupply in Zhejiang is less severe than in China overall. Zhejiang's power demand grew by 8.7% in 8M16, higher than the national average of 4.2%, while capacity is being added at a slower pace. Although we expect Zhejiang to import more power from other provinces after the completion of the Ningxia-Zhejiang ultra-high voltage transmission network, ZEG should be able to maintain its leading market position, as it is building power plants in provinces that export power to Zhejiang.

Zhejiang also introduced a trial direct-sales programme between power plants and end-users. In the trial bidding in 2016, ZEG has been able to secure 54% of the direct-sales volume from local power plants, demonstrating the company's market competitiveness arising from its large capacity share and its asset-quality and cost competitiveness. We do not expect large changes in ZEG's power segment cash generation, as price discounts on direct power-sales can be compensated for by additional power sales volume awarded by government. Zhejiang has implemented power direct-sales in a more orderly fashion than other provinces and large power generators' profitability will not decline as much.

Policy Tool for Gas-Price Controls: Zhejiang announced several policies to reduce natural gas prices in April 2016, including a CNY0.1 per cubic metre of gas cut in the midstream wholesale gas price. The policy aimed to lower corporates' operating costs while promoting clean energy. Stimulated by the price cut, gas sales in Zhejiang rebounded; gas volumes increased 25% yoy in 1H16. ZEG minimised the effect on its profitability by procuring more gas from lower-cost suppliers and passing part of the price-cut to upstream gas suppliers. At the same time, ZEG fulfilled the government's desire to lower costs for its downstream customers. The gas segment contributes less than 10% to ZEG's gross profit.

Rising Capex: We expect ZEG's capex to increase above historical levels and estimate annual capex of around CNY15bn-20bn, compared with CNY12bn in 2015. Around 45% of the capex is related to additional power capacity and around 30% is for further expansion of the province's natural gas network. Most of the remaining capex is for comprehensive energy usage projects that aim to provide power, heating, cooling and natural gas services to customers.

Investment Grade Standalone Profile: We expect ZEG's credit metrics to remain strong compared with Fitch-rated peers in China, although ZEG's EBTIDA is likely to see a mild decline due to lower power utilisation and tariffs. Incorporating the higher capex, Fitch forecasts ZEG's FFO-adjusted net leverage to deteriorate moderately to around 3.5x (end-2015: 2.6x) and for FFO interest-coverage to remain around 4.7x (end-2015: 4.9x) in the next three to four years. ZEG's operating and financial profiles place its standalone credit profile at 'BBB'.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for ZEG include:

- net consolidated power installed capacity to increase by around 4.5 gigawatts in the next four years

- coal-fired power utilisation hour to decline by 5% in 2016-2018

- power tariffs to decline from 2015 levels as more power is sold under direct power sales, which have lower tariff

- cost of coal and gas be lower in 2016 compared with 2015, before rising in 2017-2019 per Fitch's price-deck assumptions

- annual capex of around CNY15bn-20bn

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- an upgrade of Fitch's internal assessment of the creditworthiness of the Zhejiang provincial government, provided ZEG's strong operational and strategic linkages with the provincial government remain intact.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- lowering of Fitch's internal assessment of the creditworthiness of the Zhejiang provincial government, or

- evidence of a weakening of ZEG's legal, operational and strategic linkages with the Zhejiang provincial government.