OREANDA-NEWS. Fitch Ratings has assigned Bazalgette Tunnel Limited's (the borrower; BTL) GBP1bn initial revolving credit facility (RCF) a 'BBB+' rating. The Outlook is Stable.

The RCF is a 10-year bridge financing component of the borrower's GBP2.9bn financing plan for the design, construction and operation of the Thames Tideway Tunnel (the project) and associated infrastructure. The RCF is expected to be refinanced through senior secured debt issuances during the project's construction.

The rating reflects the substantial protection afforded to the project by strong support commitments from the UK government against completion and funding risk during construction. Furthermore, the project will be remunerated on the basis of a regulatory framework that Fitch regards as transparent and largely proven, under the supervision of well-established sector regulator, Ofwat. We consider the project's operational risk profile to be low. Fitch's financial analysis highlights the resiliency of financial metrics under reasonably severe downside scenarios thanks to reasonably conservative leverage targets.

Financial metrics and leverage targets could suggest a higher rating. However, the rating is weighted down by the uncertainty on the operational regulatory environment resulting from the length of the construction period. Our analysis spans beyond RCF maturity in 2025 as other senior debt ranking pari passu to the RCF will be outstanding when the project reaches the operational stage.

KEY RATING DRIVERS
Completion Risk - Midrange
The project's construction is inherently complex and lengthy. However, in Fitch's opinion, completion risk is well managed and mitigated thanks to the project's detailed planning, the involvement of several experienced contractors and personnel, a supportive regulatory framework under Ofwat's supervision and a strong support package from the UK government, which aims at providing liquidity and additional equity should severe stress scenarios materialise. GBP1.274bn will be injected by the sponsors in the first years of construction ahead of expected debt issuance and is sized in line with the most prudent overspend case.

The works will use proven technology and the construction plan, budget and schedule have been well developed drawing on directly relevant peers. The contractors were appointed following a rigorous selection process and have ample experience of similar works in London (Crossrail, Lee Tunnel and Northern Line, for example). The contracts are not fixed-price but the contractors will be incentivised through the sharing of cost savings and overruns. Overall liquidity for contractor replacement is high due to a number of adequate contractors available on the market.

Additional layers of protection include regulatory mechanisms and backstop support from the UK government. Revenues will be earned from the start of construction with costs being added to the regulated capital value (RCV) 12 months in advance, cushioning the impact of delays. Cost overruns are shared 60% with customers and the impact on the project will only be felt from completion of construction when the adjustment of RCV will occur. Delays in completion will result in a reduction in weighted average cost of capital (WACC) for the duration of the delay. Finally, in the event of cost overruns of more than 30% above P50, the project can request the government funds the additional costs. The government would then be obliged to do so or to discontinue the project and pay compensation sufficient to repay the senior debt and close hedging contracts.

Revenue Risk - Stronger
The revenue structure is based on the well-established approach used for the UK water sector and regulated by Ofwat, subject to the adjustments for the construction period. The issuer will not be exposed to volume risk but will have exposure to tariff risk every five years during operations. The project will earn a return on capital on its RCV plus be able to recover depreciation, tax and allowable opex. The RCV will increase with inflation.

Ofwat will determine WACC and opex every five years during operation (real WACC is fixed for construction). The main revenue driver will be the WACC, as opex is expected to be very small. BTL's risk profile differs in many respects from a typical water utility as it will operate a single new build asset rather than a large existing network. Ofwat has indicated that the WACC applicable to the project should be lower (by some 50bps) than other water utilities. In Fitch's opinion, the regulator's discretion over the project's key revenue drivers is lower than the sector average, given the limited operating and capital requirement post construction.

Operational Risk - Stronger
The project has very low operating risk as the tunnel uses proven technology, relies on gravity to transfer the sewage and has few moving parts. The main operating responsibilities of the project company are 10 year reviews of tunnel condition.

Infrastructure Development and Renewal - Stronger
Once completed, the assets will be brand new, with few moving parts and an economic life of 120 years. It is not expected that there will be significant need for major refurbishment for at least the first 10 years.

Debt Structure - Stronger
The RCF is senior ranking, floating rate and secured supported by a comprehensive suite of covenants including distribution controls. The RCF will rank pari passu with any future senior debt issued by the borrower. Net debt to adjusted RCV is expected not to exceed 65%.

Interest rate exposure and refinancing risk are mitigated by the regulatory financing cost adjustment mechanism, where BTL can pass through to consumers adverse movements in the market rates subject to certain thresholds. The debt market access risk during construction is further mitigated by (1) the covenant requiring capex liquidity covering 18 months of works; and (2) committed liquidity support from the government in the event of debt market disruption during construction. The super senior debt service reserve facility covering up to 12 month of projected interest, commitment and net hedging agreement payments is sufficient to bridge short-term liquidity shortfalls.

Equity injection risk is adequately mitigated by the sponsors being leading infrastructure investors who have provided letters of credit from financial institutions rated at least 'A-' in relation to 100% of the undrawn equity. The equity is scheduled to be injected ahead of material RCF draw downs.

Debt Service:
Fitch's rating case reflects a downside scenario whereby the construction process is delayed by 18 months and costs increase to 30% above P50 (the level beyond which government support would be triggered). Under these stress assumptions the project demonstrates for 2017 - 2035 period an average and minimum Fitch-calculated PMICR at 2.52x and 1.99x, respectively. The targeted 65% net debt/adjusted RCV is in line with that for similar issuers.

Fitch's sensitivity analysis shows the robustness of the company's credit profile to interest rate shocks. The stress scenario assumes maximum interest rate exposure born by the project company of 75bps, resulting in average and minimum Fitch-calculated PMICR of 2.21x and 1.55x. The results demonstrate that the project is less sensitive to the interest rate increase during the construction due to the financing cost adjustment mechanism.

Peer Analysis
BTL compares well with other secured and covenanted financings such as Wessex Water and Northumbrian Water, which are rated one notch higher at 'A-' despite weaker debt metrics. The rating differentiation reflects BTL greenfield single project nature (rather than a large operating network) and the lack of visibility on the operational regulatory environment given the long construction period ahead.

RATING SENSITIVITIES
Negative rating action may result from major construction issues jeopardising the adequacy of the existing government support. The scope for positive rating action is currently limited.