OREANDA-NEWS. Fitch Ratings has downgraded EDF SA's (EDF) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'A' from 'A+'. The subordinated notes have been downgraded to 'BBB+' from 'A-' and the Short-term IDR affirmed at 'F1'. Fitch has also downgraded EDF Energy Nuclear Generation Group Ltd's Long-term IDR to 'A' from 'A+'. The Outlooks on the Long-term IDRs are Stable.

The downgrade reflects that EDF's earnings growth is insufficient to offset the impact of sizeable negative free cash flow on the debt position and financial gearing. Fitch also expects that the tariff progression for household customers in France will continue to be slow and that competition for commercial customers will put pressure on the group's margins.

KEY RATING DRIVERS
Strongest Profile in EU Industry
EDF's ratings reflect a strong business profile underpinned by its dominant position in its domestic market, and unparalleled CO2 free fuel mix including nuclear, hydro and renewables, compared with its European peers. Its market position and asset portfolio composition have helped protect EDF's earnings and profitability in a period of structural decline for the European power generation industry, characterised by depressed demand, strong growth in renewable capacity and subsequently falling wholesale electricity prices.

Slow Evolution of Business Risk
EDF's French generation and supply activities will be increasingly exposed to competitive pressures and market dynamics. However, the group plans to invest heavily in regulated assets, including networks and smart metering, and earn additional income from capacity markets in France and the UK. Overall the business risk may only incrementally weaken over time. Consequently, Fitch has decided not to change the boundary between 'A' and 'A+' for EDF's ratings at funds from operations (FFO) adjusted net leverage of 3.0x.

Financial Profile Warrants 'A' Rating
EDF's FFO adjusted net leverage was 3.4x and FFO fixed charge cover was 4.3x for FY14. Adjusting the debt position for over-funding of the dedicated asset pool and some movements within financial assets, the FFO adjusted net leverage would be closer to 3.2x on a pro forma basis. These historical metrics and our forecasts are in line with the ratio guidelines for a 'A' Long-term IDR.

Significant Capex Creates Additional Financial Stress
The expected on-balance sheet funding of AREVA, the continuing Flamanville cost overrun, and the roll-out of smart meters creates additional pressure on EDF's balance sheet over the rating horizon, and could drive FFO net leverage towards 4.0x by 2018. We expect AREVA to cost EDF EUR1.5bn-EUR2.0bn, and meters to result at peak in a further EUR1bn of capex per year. However, we do not expect the investments to contribute meaningful cash flow for some time. Earnings growth is thus not sufficient to offset sizeable negative free cash flow.

Waning Support for Full Recovery of Nuclear Cost
Wholesale electricity prices in Europe are often below all-in production costs for nuclear generation. As a result further tariff rises are more difficult to justify and the proportion of production that is linked to regulated tariffs is reducing. This means EDF's earnings from generation and supply activities are becoming more exposed to market dynamics. The French government introduced an element of market pricing into regulated tariffs in October 2014, and yellow and green regulated tariffs will be phased out by the end of 2015. In the past, the French government successively raised electricity tariffs from a very low base.

The French Government, the European Commission and EDF appear not to have reached a consensus on the formula for the ARENH (regulated access to incumbent nuclear electricity) price. Affordability concerns, in particular when it comes to household customers, have guided recent tariff decisions.

Since December 2010, the NOME law has stipulated that regulated tariffs should rise over time to include "the full economic cost of existing nuclear capacity" by the end of 2015, which was estimated by the French comptroller's office to be EUR49.5/MWh (at 2010 prices). While the NOME law remains in force, its practical relevance is fading, and political pressure to change the current framework is increasing as market developments have challenged the energy landscape in Europe over the past five years.

Energy Transition for Green Growth
The energy transition bill confirmed in July 2015 will result in increased spending on renewables and a reduction in both fossil-fuel and nuclear generation. However, this should lead to an extension of lifetimes for most nuclear power plants, and a more diversified electricity mix overall. Fitch notes that subsidies for the renewables build-out will increase the cost base and add some fuel to the controversial debate related to tariff decisions.

Material Investment into Smart Metering
Taking into account capex requirements for the smart meter roll out programme (Linky), Fitch expects EDF to remain free cash flow negative until at least 2020. However, EDF is committed to be free cash flow positive from 2018 excluding Linky. The French network subsidiary needs to roll out 35 million smart meters across 2015-21, with expected capital expenditure of around EUR5bn. EDF should earn 7.25% plus incentives p.a. on the assets, depending on cost control, progress of build-out and system performance. Customers will only be charged from 2023 onwards, with outstanding remuneration to be capitalised until then.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for EDF include:
- Slightly decreasing earnings in the French operations in comparison with FY14
- Incremental earnings growth in the UK due to good operational performance of nuclear plants and favourable development of sterling
- Newly raised debt to be priced at 4.0%
- Capital expenditure in line with management guidance
- Continued payment of cash dividends

RATING SENSITIVITIES
Positive: Future developments that may lead to positive rating action include:
- FFO lease adjusted net leverage below 3.0x on a sustained basis
- FFO fixed charge cover above 5.0x on a sustained basis
- We do not expect the business profile to strengthen

Negative: Future developments that may lead to negative rating action include:
- FFO lease adjusted net leverage above 4.0x on a sustained basis
- FFO fixed charge cover below 4.0x on a sustained basis
- Structural changes that result in enhanced competition in the French electricity market and other events that contribute to increased business risk

LIQUIDITY
At June 2015 EDF had sufficient liquidity comprising cash and cash equivalents of EUR3.0bn, short-term liquid investments of EUR12.3bn and committed undrawn facilities of EUR8.7bn (with medium-term maturities). This funding position means that EDF can cover scheduled debt maturities (mainly short-term debt of EUR14.9bn), capital expenditure, operating requirements and dividends into 2017 without resorting to additional debt raising.