OREANDA-NEWS. December 08, 2015. Fitch Ratings says the final determination of the Italian regulator Autorita per l'Energia Elettrica, il Gas ed il Sistema Idrico (AEEGSI) on the return on capital for regulated gas and electricity activities is credit positive for Italian network operators. The impact will be significant for Terna S.p.A. (BBB+/Stable) and Snam S.p.A. (BBB+/Stable), while Enel S.p.A. (BBB+/Stable), Acea S.p.A. (BBB+/Stable), Iren S.p.A. (BBB-/Stable) and Linea Group Holding (LGH, BBB-/Stable) will benefit to a more limited extent.

The application of the new formula from 2016 leads to a weighted average cost of capital (WACC, real pre-tax) of 5.4% for gas transport (currently 6.3%), 6.1% for gas distribution (6.9%) and 6.5% for gas storage (6.0%). For electricity, the WACC will be defined by the end of year, together with the determination of the framework for the new regulatory period. Fitch does not anticipate major differences compared with gas for transmission and foresees a somewhat lower return for distribution, again with a downward trend in relation to the existing level.

Fitch believes that the downward revision of the remuneration for Italian networks is consistent with the current interest rates environment. The new framework aligns the return dynamics for gas and electricity activities and gives more stability and visibility to the remuneration, while retaining some flexibility through the update of some key drivers (risk-free rate, country risk premium only if triggered) after three years.

The WACC levels defined by the regulator are better than those conservatively included in our rating cases (slightly below 5% for transport and in the 5%- 5.5% range for distribution).

Factoring in the WACC determined by the regulator or expected shortly, we note that Snam and Terna are the most positively affected by the redetermination. Snam and Terna's funds from operations (FFO) net adjusted leverage decreases by around 0.3x from 2016. This increases the limited headroom that both companies had for their rating. For Enel and Italian multi-utilities (Acea, Iren, LGH), the impact on the FFO net adjusted leverage is expected to be more modest, at around 0.1x, due to the moderate weight of electricity and gas distribution on their total EBITDA.

The WACC is currently determined separately for each regulated activity at the beginning of its regulatory period and is linked to the Italian 10-year government bond yield, assumed as risk-free rate. We note that the rate of return would have been very low applying the outstanding formula, based on 2015 evidence.

The AEEGSI has undertaken a comprehensive revision of the WACC formula inputs, aimed at reducing the volatility of the rate of return over time. The regulator has also introduced a regulatory period of the WACC of six years (2016-2021). The drivers of the formula will be determined at the beginning of the period and will be the same for all the regulated activities of the gas and electricity businesses in Italy, with the only activity-specific parameters being the beta and the gearing ratio. The revision process has been transparent with all the stakeholders fully involved.

The regulator has based the new formula directly on real values, rather than on nominal values with the application of the expected inflation. The risk-free rate is now based on the 10-year real bond yield of four European 'AA' rated countries, with a floor set at 0.5%. In addition, a country risk premium (CRP) of 1%, based on historical evidence, is applied to determine both the cost of debt and the cost of equity. The formula determines the equity risk premium as a difference between the real total market return, based on long-term historical evidence and set at 6.0%, and the risk-free rate.

The spread considered for defining the cost of debt has been kept broadly flat at 0.5%, while the tax rate has been lowered to 34.4% (however the WACC is adequately rectified to consider that taxes would be paid on the basis of nominal returns). The gearing ratio (44.4% for most of the activities) will be kept at the current level for 2016-18.

An interim revision of the formula is expected after three years (2019). The updated drivers will be the risk-free rate, the tax rate, the gearing and the CRP. The gearing will likely be increased to gradually align it to the other European regulatory frameworks. The CRP would only be updated if the spread between Italian and German government bond yields increases by more than 20% compared with the reference level observed in October 2014-September 2015.

The risk-free rate has been initially set at the floor level of 0.5%, due to the currently negative government bond yields of 'AA' rated countries. Its potential increase in 2019 would be partly offset by the reduction of the equity risk premium, calculated as a difference with the total market return, which is kept flat for the whole six-year period.