OREANDA-NEWS. March 23, 2015. Fitch Ratings has affirmed Northern Powergrid Holdings Company's (Northern Powergrid) Long-term Issuer Default Rating (IDR) at 'BBB+', senior unsecured rating at 'A-' and Short-term IDR at 'F2'. The agency has simultaneously affirmed the group's two distribution network operating businesses (DNOs), Northern Powergrid (Northeast) Limited's (NPN) and Northern Powergrid (Yorkshire) plc's (NPY) Long-term IDRs at 'A-', senior unsecured ratings at 'A', and Short-term IDRs at 'F2'. The Outlooks on the Long-term IDRs are Negative. A full list of the rating actions is at the end of this release.

The affirmation reflects the group's conservative financing structure and the final determinations of the GB energy regulator, Ofgem, for slow-tracked DNOs under the new price control RIIO-ED1 (ED1). The Negative Outlook reflects our expectations that post maintenance interest cover ratio (PMICR) of the group and its operating entities during ED1 will remain under pressure while gearing metrics in terms of net debt/regulatory asset value (RAV) will remain strong for the rating. We could revise the Outlook to Stable once we have more clarity regarding the group's first year performance in ED1, in particular, the level of outperformance that we incorporate in our forecasts.

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 ED1 compared with the current price control (DPCR5), although Fitch judges the overall impact as ratings neutral. The price control period increased to eight years versus five previously. The depreciation lives of new assets have been extended to 45 from 20 years, mitigated by a transition period. This is offset by Ofgem continuing to fund the pension deficit to 2025, retaining re-openers from DPCR5 to address uncertainties and close the losses mechanism from DPCR5. Also, companies can earn additional returns through outperformance against total expenditure allowances and incentive revenues.

The weighted average cost of capital is set at 3.76% against 4.69% in DPCR5 and is based on the allowed cost of debt at 2.55% real for 2015/16, which will follow the iBoxx index, setting a tougher benchmark to deliver against. We estimate that Northern Powergrid's return on regulated equity could go down by as much as 30% during ED1 versus DPCR5, excluding the RPI impact, due to the combination of tougher output targets and lower allowances in the ED1 final determinations.

Operational Performance Exceeding Regulatory Targets
During DPCR5 Northern Powergrid outperformed cost targets embedded into the tariff settlement as well as operational targets such as interruption statistics. Management estimates total cost outperformance at around 8% versus the allowances. The company has delivered a large investment programme and at the same time improved both reliability and customer service performance. While Ofgem has tightened the output targets and lowered total expenditure allowances under ED1, Fitch estimates that both NPN and NPY would still be able to achieve some outperformance in view of their track records. According to management, any cost outperformance would be reinvested to drive output improvement.

Strong Gearing, Tight PMICR
As of December 2014 group gearing stood at 58%, which is expected to increase towards, but not exceed the regulatory gearing assumption of 65%. Equity headroom could be distributed to Northern Powergrid's shareholder, Berkshire Hathaway Energy Company (BHEC, BBB+/Stable). Additional debt would be raised by the operating companies. Fitch notes that due to a financial covenant in the GBP200m holding company bond maturing in 2022, the group could only raise debt if its consolidated senior net debt to RAV does not exceed 65%. Fitch considers the projected average gearing of 64% is strong for Northern Powergrid's 'BBB+' IDR with ample headroom versus our negative guidance of 75%. As for the operating entities NPN and NPY, we expect their gearing to average 53% and 54%, respectively, during the eight-year price control period. These levels also compare favourably with our negative guidance of 60% for a 'A-' IDR.

Fitch estimates PMICR to be around 1.6x for Northern Powergrid, 1.9x for NPN and 1.8x for NPY (eight-year average over the price control period). These interest cover ratios are at, or for NPY slightly below, our downgrade guidance for the rating of 1.6x for the group and 1.9x for the operating companies, but they incorporate assumptions on the incentive income which may not materialise due to tougher output targets. We expect actual performance under ED1 to give us more visibility in this area and comfort for a possible revision of the Outlook.

In arriving at NPY's PMICR, we take into account the company's intention to reduce dividend distributions to the level assumed by Ofgem (5% of the notional equity portion of RAV) for as long as the entity's interest coverage ratio remains under pressure versus our negative guidance. However, we note that given materially stronger gearing, there is some capacity to tolerate interest cover slightly below the rating guidance.

Supportive Shareholder
Northern Powergrid is fully owned by BHEC, which is in turn 90%-owned by Berkshire Hathaway Inc (AA-/Stable). BHEC takes a long-term view of its investment in Northern Powergrid and has taken no dividends since 2003. Although higher dividend distributions remain an option to bring the capital structure in line with Ofgem's assumptions, there is flexibility around dividend payments within BHEC. Fitch incorporates supportiveness of the shareholder in its rating assessment.

CMA Appeal Rating Neutral
In March 2015 Northern Powergrid filed an appeal regarding the ED1 determination. The appeal specifically relates to three areas: smart grid benefits, real price effects and regional labour cost adjustments. We do not expect the outcomes of this appeal to have a material impact on Northern Powergrid's financial profile or ratings due to its relatively modest size and due to the company's intention to re-invest any additional allowances into output improvements. We note that British Gas's appeal to modify the licenses of the 10 DNOs may result in changes to ED1.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- RPI of 2.0% for FY16 and 2.5% flat thereafter
- Allowed cost of debt under Ofgem's IBOXX trombone mechanism goes down from 2.55% in FY16 to 2.06% in FY23
- Average cost of debt for the eight-year price control is 5.7% for Northern Powergrid, 5.2% for NPN and 5.1% for NPY
- Incentive revenue is assumed at around GBP8m for NPN and GBP12m for NPY real per annum for the whole price control
- Zero totex outperformance is assumed
- All other information regarding revenue allowances mirrors Ofgem's final determinations

RATING SENSITIVITIES
Fitch will review operating performance and evolution of macro-economic conditions in the first year of the price control period to decide whether to increase, maintain or decrease the level of outperformance in the rating forecast. This evidence should assist in the decision to downgrade the ratings or revise the Outlook to Stable.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- The Outlook is Negative and we therefore see an upgrade as unlikely. Rating upside is limited if management maintains a capital structure not materially deviating from the regulator's 65% notional gearing.
- Strong outperformance of regulatory targets in ED1 price control period along with moderate dividend distribution could lead to stabilisation of the Outlook.

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
- Northern Powergrid: leverage (net debt/RAV) above 75% and PMICR falling materially below 1.6x, both on a sustained basis.
- NPN and NPY: Weak regulatory and operational performance or increase in dividends that adversely affect the cash flow position, taking net debt/RAV above 60% and PMICR below 1.9x, both on a sustained basis.

The agency is unlikely to downgrade ratings for interest cover marginally below guidelines, as long as gearing continues to be at materially lower levels in comparison to the applicable guidelines.

LIQUIDITY
As of December 2014, Northern Powergrid held GBP3m in cash and cash equivalents and had in place a committed revolving credit facility of GBP150m with maturity in August 2017, of which GBP118m was drawn. The nearest debt maturity is GBP40m in 2018. We forecast significant negative free cash flow of GBP144m assuming a dividend is paid in FY ending March 2016. The company plans to fund it via new debt issuance at the operating entities. Northern Powergrid's liquidity is therefore reliant on capital market access.

The rating actions are as follows:

Northern Powergrid:
Long-term IDR: affirmed at 'BBB+'; Outlook Negative
Senior unsecured rating: affirmed at 'A-'
Short-term IDR: affirmed at 'F2'

Yorkshire Power Group Limited:
Long-term IDR: affirmed at 'BBB+'; Outlook Negative
Short-term IDR: affirmed at 'F2'
Yorkshire Power Finance Ltd:
Senior unsecured notes affirmed at 'A-', guaranteed by Yorkshire Power Group Limited

Yorkshire Electricity Group plc:
Long-term IDR: affirmed at 'BBB+'; Outlook Negative
Short-term IDR: affirmed at 'F2'

Northern Electric plc:
Long-term IDR: affirmed at 'BBB+'; Outlook Negative
Short-term IDR: affirmed at 'F2'

NPN:
Long-term IDR: affirmed at 'A-'; Outlook Negative
Short-term IDR: affirmed at 'F2'

Northern Electric Finance Plc:
Senior unsecured notes: affirmed at 'A'; guaranteed by NPN

NPY:
Long-term IDR: affirmed at 'A-'; Outlook Negative
Senior unsecured rating: affirmed at 'A'
Short-term IDR: affirmed at 'F2'