OREANDA-NEWS. Fitch Ratings has affirmed Zhejiang Provincial Energy Group Company Ltd.'s (ZEG) Long-Term Issuer Default Rating (IDR) at 'A' 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) Company Limited (ZEHK) at 'A'. In place of a guarantee, ZEG has granted a keepwell, liquidity support, and equity interest purchase covenants deed to ensure that 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. By end-2014, ZEG accounted for around half of Zhejiang province's installed power capacity and half of the power generated annually. In addition ZEG is also the monopoly midstream natural gas distributor and the largest coal trader in Zhejiang province. ZEG has regularly received government support, including favourable allocation of quality energy resources, state-administered zero-cost asset transfers and various forms of government grants and subsidies.

Resilient Power Generation Operations: ZEG has managed to achieve robust profits from power generation despite weak power demand in Zhejiang province. ZEG's total power generation dropped slightly in 2014 despite an 11% increase in its installed capacity, and the average coal power on-grid tariff being cut by CNY0.026 (6%-7%) per kilowatt since late 2013. In addition to weak demand, higher supplies from other provinces to Zhejiang have also impacted the company adversely. As a result ZEG's 2014 revenue from power generation dropped 9% yoy. However, the negative impact from lower utilisation was largely mitigated by the declining fuel cost and thus the gross margin for power generation remained largely stable. Power demand in the province continues to be weak, increasing just 3% yoy in 1H15, but we expect profits from power generation to remain broadly stable as the China domestic coal price has fallen 15%-20% since end-2014.

Increasing Natural Gas Coverage: As the monopoly midstream natural gas provider within the province, ZEG continued to improve the natural gas distribution network in Zhejiang by constructing long-distance pipelines connecting major cities in the province. ZEG expects to complete the two remaining provincial trunk gas pipelines by 2016. ZEG's midstream natural gas wholesale volume increased by 25% to 6.7bn cubic meters in 2014. In the short term, Fitch expects ZEG's gas sales to be weak because of a decline in demand from gas-fuelled power stations due to weak power demand and competition from other energy sources. In the long run, we expect ZEG's gas wholesale growth to remain at the mid-teens, driven by the national target to promote use of natural gas and ZEG's expanding gas pipeline network.

Investment Grade Standalone Profile: Although we now expect ZEG's improvement in credit metrics to be slower than previously anticipated, ZEG's standalone credit profile continues to be strong and is in line with that of other 'BBB' category utility companies that Fitch rates in China. Fitch forecasts its funds from operations (FFO) adjusted net leverage to be below 3.0x (end-2014: 3.2x) and FFO interest coverage above 5.0x (end-2014: 4.6x) in the next three to four years. However ZEG's operating risk profile is constrained by the regulatory environment in China's power sector, including a less-transparent fuel cost pass-through mechanism and evolving competition landscape, with further power-sector reforms ahead. However, these risks are partially mitigated by ZEG's high percentage of large-scale, energy-efficient coal-fired units and its dominant market position within Zhejiang province.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:
- Consolidated power installed capacity to increase by around 5 gigawatts in the next three to four years
- Power plant capacity utilisation to drop 5%-10% per year in 2015 and 2016 given weak demand and increasing capacity within the province
- Fuel price to remain stable at around first-half 2015 level.
- Annual capex in the next three to four years to be moderately lower compared with CNY15bn in 2014

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 Zhejiang 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.