OREANDA-NEWS. Fitch Ratings has revised Germany-based RWE AG's (RWE) Outlook to Negative from Stable and affirmed its Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+', Short-term IDR at 'F2' and subordinated note rating at 'BBB-'. Fitch has also affirmed RWE Finance B.V.'s notes, which are guaranteed by RWE, at 'BBB+'.

The rating action reflects RWE's declining earnings and a challenging operating environment, but also an increasing proportion of regulated and quasi-regulated earnings, which will support the business profile. Using current market prices Fitch assesses RWE's earnings and debt capacity as weak for a 'BBB+' Long-term IDR. Headroom has been eroded by weaker electricity pricing and, to a lesser extent, by limitations to offset taxable income with tax losses across the group. This is reflected in the change in Outlook to Negative.

Any additional burden from increasing carbon costs or other obligations related to energy market reform would likely result in a downgrade to 'BBB'. We assume that RWE has little scope to pursue further efficiencies, reduction of capital expenditure or hybrid issuance. While RWE has progressed with closure, mothballing or cancellation of contracts related to 8,310MW of generation assets (located in Germany and the Netherlands), prospective policy measures may result in further adjustments to the generation portfolio.

KEY RATING DRIVERS

Forecast Earnings Continue to Decline
Forward electricity prices in Germany have fallen to around EUR32/MWh and clean dark spreads to below EUR3.50/MWh for baseload, further reducing earnings from conventional generation. Also, Fitch has increased its estimate of cash taxes following management guidance of a higher effective tax rate over the medium-term; there are limitations to offsetting taxable income with tax losses across the group, particularly in the German operations.

Rating Headroom Eroded
Our latest forecasts show nuclear- and lease-adjusted funds from operations (FFO) net leverage at moderately above 4.0x for 2015 and 2016 and fixed charge cover around 3.5x. This reflects lower earnings from conventional generation as hedges roll off, only partly offset by newly commissioned renewables capacity, efficiency measures, positive FX effects from sterling and few smaller disposals.

We expect leverage and fixed charge cover to improve to 4.0x and to 3.9x, respectively, in 2018, mainly due to the nuclear fuel tax expiring. Capacity payments in the UK will support earnings from the winter of 2018/19. Overall, credit metrics are weak, leading to today's revision of Outlook.

Government Intervention in Carbon Market
Policy makers have established that carbon reduction targets for 2020 require further efforts. Proposals for a carbon levy on older coal-fired power stations that were tabled earlier in the year proved to be controversial and have now been abandoned. Instead the coalition decided on 1 July 2015 to move 2.7GW of old coal-plants into a capacity reserve for which utilities will be remunerated. Detail on the compensation mechanism and earnings impact on RWE and Vattenfall AB (A-/Negative) are not yet available.

To date the government has been a clear proponent of renewables and opponent of nuclear. In turn, there is no policy objective regarding the target generation mix for thermal baseload and flexible back-up capacity. The government's reactive approach and lack of a long-term strategy make it difficult for utilities to plan maintenance investments related to existing generation capacity and exposes them to political risks/election cycles.

Activities Concentrated in Competitive Markets
Following disposal of the upstream oil and gas assets and margin erosion of conventional generation, an increasing proportion of RWE's earnings is coming from regulated businesses, including electricity, gas and water networks or renewables. The latter benefits from feed-in-tariffs/other support mechanisms (quasi-regulated activities). Overall, business risk is improving, although the group remains concentrated in difficult continental European markets. We view RWE's business profile as weaker than most large European utilities.

Continued Investment Discipline
The offshore windfarms Gywnt y Mor and Nordsee Ost were commissioned in 1H15 and the hard-coal power plant in Eemshaven in the Netherlands will start operations later in 2015. Thereafter, RWE has guided towards capex of EUR2bn, focusing on maintenance of existing assets and selected growth projects with solid earnings and return visibility. Fitch has included in its forecast capital expenditure of EUR2bn for 2016 and EUR2.5bn for 2017 and 2018.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for RWE include:
- Germany electricity forward price of EUR32/MWh and clean dark spread of around EUR3.00-3.50/MWh
- Utilisation of provisions and negative cash-flow items not represented in EBITDA to increase to around EUR1bn (outflows) per annum over the medium-term
- FFO in 2015 and 2016 to be broadly similar to last year and to increase to EUR3.5bn thereafter
- Low to mid-triple-digit million working capital outflows each year
- Capital expenditure in line with group guidance, but to increase to EUR2.5bn in the medium-term
- Positive free cash flow of about EUR250m per year on average from 2016 onwards

RATING SENSITIVITIES

Positive: Future developments that may lead to a stabilisation of the ratings include:
- A visible improvement of forecast financial metrics with lease- and nuclear-adjusted FFO net leverage below 4.0x and corresponding fixed charge cover above 4.0x.
- The German Constitutional Court rendering the nuclear fuel tax as unconstitutional, with funds being returned to the nuclear operators.

Negative: Future developments that may lead to negative rating action include:
- Lease- and nuclear-adjusted FFO net leverage above 4.0x and corresponding fixed charge cover below 4x on a sustained basis.
- Increasing carbon costs with impact on RWE's conventional generation segment; the group has a very high carbon footprint.
- Other elements of energy market reform in Germany (or possibly in other countries) creating additional costs that cannot be passed on to consumers.
- Establishing a public nuclear fund, depending on associated valuation of obligations and or timing of funding requirements.
- Corporate activity or less restraint on capital expenditure.
- Weak financial results resulting in negative free cash flow beyond 2015.

The rating sensitivities highlight that downside risks dominate. Fitch will take negative rating action as and when government policies reinforce any of these negative rating sensitivities.

LIQUIDITY AND DEBT STRUCTURE

RWE's liquidity remains strong. As of 31 March 2015, the group held EUR3.3bn of cash and cash equivalents, EUR6.2bn of short-term securities (after deducting around EUR600m for restricted holdings, an estimate reflecting historical levels; the precise amount was not disclosed for March 2015) and EUR4bn of committed, undrawn revolving credit facilities with maturity in March 2020. Additionally, RWE raised EUR1.25bn of hybrid capital in two tranches on 21 April 2015.

The group has short-term maturities of EUR1.8bn and is expected to call its EUR1.75bn hybrid in September 2015. Considering that management aims to be free cash flow-positive from 2016, the current funding position should comfortably see the group into 2018.