OREANDA-NEWS. Fitch Ratings has downgraded London Power Networks (LPN)'s Issuer Default Rating (IDR) to 'BBB' from 'BBB+' and removed it from Rating Watch Negative (RWN). It has also affirmed South Eastern Power Networks (SPN) and Eastern Power Networks (EPN)'s Long-term IDRs at 'BBB'. Fitch has also downgraded LPN's senior unsecured rating to 'BBB+' and removed it from RWN and affirmed SPN and EPN's senior unsecured ratings at 'BBB+'. The Outlook on EPN has been revised to Stable from Negative. The Outlooks on LPN and SPN are Stable. A full list of rating actions is at the end of this commentary.

The rating actions reflect the UK regulator's draft and final determinations setting remuneration for electricity distribution companies (DNOs) from April 2015 to March 2023 (ED-1). The downgrade of LPN reflects a fall in headline post maintenance interest cover ratio (PMICR) from an average 2.2x under DPCR5 to an average 1.5x under ED-1. The revision of the Outlook on EPN reflects a more modest fall in PMICR from an average of around 1.8x to 1.5x across regulatory periods. LPN, EPN and SPN all bought back expensive debt at the end of 2014 and EPN and SPN issued index linked debt at a very low cost this year. Fitch has revised assumptions for RPI and the cost of new debt over ED1.

KEY RATING DRIVERS
Tougher Regulation from April 2015
Ofgem published its final determination in November 2014. Business risk for DNOs has increased slightly as a result of the new price control (RIIO-ED1) compared to DPCR5, although Fitch judges the overall impact as ratings neutral. The price control period increased to eight years, although depreciation lives were extended to 45 from 20 years for new assets, mitigated by a transition period. This is offset by Ofgem funding the full pension deficit over 15 years and retaining re-openers from DPCR5 to address uncertainties and close out the losses mechanism from DPCR4. Also, companies can earn additional returns through outperformance against total expenditure allowances and incentive revenues.

WACC is set at 3.76% against 4.6% in DPCR5 and the cost of capital is based on a cost of debt set at 2.55% real for 2015/16 but this will fall following the iBoxx index, setting a tougher benchmark to deliver against.

Incentive Revenues Outperformance
Operating performance on 2014 customer interruptions (CI) and minutes lost (CML) was well ahead of Ofgem targets and contribute GBP45m-GBP50m of incentives in additional revenues. Although targets have been tightened with respect to DPCR5 and incentive rates are now subject to a sharing factor, Fitch believes there is scope for UKPN to achieve continued outperformance albeit at a lower level compared to DPCR5. Efficiency initiatives implemented by management over DPCR5 and the introduction of more innovative and efficient processes will help the DNOs achieve regulatory targets. Fitch estimates include an assumed haircut of 30% from FY18 to FY23 to company figures.

Totex Outperformance
UKPN underperformed totex (opex and capex) allowances at group level by GBP6.2m in FY14, notably at EPN. This is because the companies had deferred load related capex to the later years of DPCR5 due to the downturn. However, we expect all three DNOs to achieve totex outperformance over ED1. Volume efficiency will be achieved by re-engineering the plan to remove unnecessary work volumes and target actual volumes replaced at those assets to deliver the highest output benefit. Fitch forecasts assume totex outperformance of 6.6% for LPN and 6.8% for both SPN and EPN.

Proactive Treasury Management
Treasury has actively addressed the impact on PMICR of reduced cash flow generation over ED1 by carrying out debt repurchases. In September 2014, UKPN bought back GBP150m nominal value of bonds for GBP189m (LPN due 2016, EPN due 2025 and SPN due 2026). This improved FY14 PMICRs, although there has been a small increase in leverage (net debt/ RAV). UKPN has included a number of interest rates swaps in the capital structures of LPN and SPN in 2014 giving a cash interest benefit in the early years of the ED1.

Improved Credit Metrics
Management has reduced ceiling gearing to 69% for EPN while keeping ceiling gearing for LPN and SPN at 72%. All three DNOs current gearing levels are significantly below their respective ceiling levels. The reduction in ceiling gearing at EPN announced in December 2014 shows a commitment to maintain EPN's senior unsecured rating of 'BBB+' following the revision of the Outlook to Negative Outlook in August. Forecast credit metrics for EPN have improved from our assessment based on the draft determination to Final Determination with repurchase of expensive debt at the end of 2014, issuance of index linked debt at a very low cost of 0.25% plus RPI and revised assumptions for inflation and cost of new debt over ED1.

KEY ASSUMPTIONS
Fitch's core macro assumptions include RPI of 2.0% for FY16 and flat 2.5% from FY17. Our assumption is of a 1.13% real cost of debt in FY15 and flat 1.4% from FY16. This takes the cost of debt lower each year under Ofgem's iBoxx trombone mechanism, starting at 2.55% in FY16 and falling to 2.06% by FY23. This implies a nominal cost of new debt of 3.13% for FY15 and 3.9% from FY16 onwards. We estimate incentive revenues related to CI's and CML's for FY15 and FY16 and assume a haircut of 30% to incentive revenues from FY18. We also estimate differing levels of totex outperformance per DNO.

Stressing RPI 1% lower at 1.5% would have the effect of improving PMICR ratios across all three DNOs because of the presence of index linked debt and because Fitch forecasts are flexed by dividends. Dividends would need to be cut by just over 12% over ED-1 to achieve this improvement. We assume steady leverage as per the management guidance (72% for LPN and SPN and 69% for EPN reflecting its relatively higher cost of debt).

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

- Material outperformance of regulatory targets placing the DNO in the top third quartile by regulatory performance plus a PMICR above 1.6x and leverage (net debt/ RAV) below 70%, both on a sustained basis.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Lack of improvement in regulatory & operational performance or increase in dividends that adversely affect the cash flow position, taking leverage (net debt/ RAV) above 72% or PMICR falling below 1.4x, both on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE
As of February 2015, the three DNOs had a total of GBP90.4m in cash and cash equivalents and undrawn committed bank facilities of GBP346m expiring in February 2017. Fitch believes the DNOs have adequate liquidity to meet operating requirements despite aggressive dividend assumptions reflecting leverage (net debt/ RAV) of 72% at LPN & SPN and 69% at EPN. On a standalone basis, LPN, SPN and EPN have adequate liquidity to meet financial requirements until 2016.

FULL LIST OF RATING ACTIONS
London Power Networks plc
-Long-term IDR: downgraded to 'BBB' from 'BBB+'; Outlook Stable, off RWN
-Senior unsecured rating: downgraded to 'BBB+' from 'A-', off RWN
-Short-term IDR: downgraded to 'F3' from 'F2'; off RWN

South Eastern Power Networks plc:
-Long-term IDR: affirmed at 'BBB'; Outlook Stable
-Senior unsecured rating: affirmed at 'BBB+'
-Short-term IDR: affirmed at 'F3'

Eastern Power Networks plc:
-Long-term IDR: affirmed at 'BBB'; Outlook revised to Stable from Negative
-Senior unsecured rating: affirmed at 'BBB+'
-Short-term IDR: affirmed at 'F3'