OREANDA-NEWS. Fitch Ratings has downgraded Vattenfall AB's Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB+' from 'A-'. The Outlook on the IDR is Stable. Fitch has also rated Vattenfall's hybrid securities issued in 2015 at 'BBB-'. A full list of rating actions is at the end of this commentary.

The downgrade reflects pressure on cash flow in Vattenfall's key operating segment, power generation, due to declining achieved power prices in the next few years and our expectation that the negative leverage guidance for the previous 'A-' rating will be breached within the rating horizon. This is despite a modest deleveraging resulting from continued asset disposals and the hybrid bond issuance. We expect that Vattenfall will maintain leverage within guidance for the 'BBB+' rating due to reduced capital expenditure, strategic re-orientation with lignite assets disposal and cost reduction measures helping to mitigate falling achieved power prices.

KEY RATING DRIVERS
Deteriorating Forecast Performance
We expect Vattenfall's funds from operations (FFO) adjusted net leverage to increase by 2017-2018 but remain within our guidance of below 4.5x for the 'BBB+' rating. The leverage increase will be driven mostly by weaker operating cash flow in power generation reflecting low achieved power prices in the range of EUR25 to EUR30 per megawatt hour (MWh). The impact of weaker operating cash flow will be mitigated by a much-reduced capital expenditure programme and the prospective sale of lignite assets.

Low Wholesale Power Prices
Wholesale power prices remain low in Vattenfall's key markets, negatively impacting results in generation. Vattenfall's power price hedging is protecting the company from low spot prices in Germany and the Nordic region and delaying the impact of declining forward prices in these two markets. Spot power prices in the Nordic region fell temporarily to around EUR10-EUR15/MWh in 3Q15 from around EUR30/MWh in early 2015, due to exceptionally high hydro reservoir levels and weak power demand. We expect Vattenfall's achieved power price to fall over the rating horizon, as its ability to protect itself from low wholesale prices diminishes with hedges rolling off. We expect broad equalisation between hedged and forward prices by 2018.

Lignite Business Divestment
Vattenfall is moving forward in its disposal process of German lignite assets, which represent annual generation of around 55TWh from installed capacity of around 8GW. Vattenfall received statements of interest from potential bidders in October 2015 and has identified a shortlist of bidders. The company expects to sign a deal by mid-2016. The disposal of the lignite assets should be credit positive thanks to the reduction in net debt due to the cash proceeds. We expect that the likely long-term rise in the market price of CO2 allowances will negatively impact the value of lignite-fired generation.

Well-Diversified Business Profile
Vattenfall is a leading European integrated utility taking into account its size, geographical coverage and good fuel mix diversification. Most of the company's revenues are generated in Sweden and Germany, but it operates in other European jurisdictions. Vattenfall's annual electricity production was at 173TWh in 2014 with the generation fuel mix fairly diversified between lignite, nuclear energy, hydro and hard coal, complemented by gas, wind and biomass/waste. The company has also large power distribution (83TWh in 2014) and heat operations (24TWh in 2014) which provide stable regulated and quasi-regulated EBITDA.

Strategic Re-Orientation
Vattenfall is investing in wind power generation (currently 4TWh p.a.). It has also brought forward the closure of Ringhals nuclear units 1 and 2 (2019-2020 instead of 2025), which together with lignite disposal will lead to a structural change in the company's business and EBITDA structure. Vattenfall's regulated (power distribution) and quasi-regulated (wind, heat) activities will play a growing role and increase their shares in EBITDA, which would be positive for the company's credit profile, despite the smaller revenue base and relatively higher maintenance demands of the network assets.

New Hybrids Attract 50% Equity Credit
During 2015, Vattenfall refinanced its EUR1bn hybrid security with four new hybrids - two SEK3bn and EUR1bn securities issued on 19 March and USD400m security issued on 19 November 2015. We rate the four hybrid issues at 'BBB-', two notches below Vattenfall's IDR, given their deep subordination and consequently lower recovery prospects in a liquidation or bankruptcy scenario relative to senior obligations. The securities qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, remaining effective maturity of at least five years, full discretion to defer coupons for at least five years and limited events of default.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Vattenfall include:
- Achieved power prices in the range of EUR25 to EUR30 per MWh
- Disposal of Vattenfall's lignite business by the end of 2016 and termination of generation in Ringhals 1 and 2 in 2019-2020
- Gradual increase in wind generation
- No major shifts in distribution volume and remuneration
- Continuation of the savings programme
- CAPEX at SEK93bn in 2015-2019
- No dividends for 2015

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Lease- and nuclear- adjusted FFO net leverage below 3.75x and/or corresponding fixed charge cover materially above 4.0x on a sustained basis.
- Stabilization of EBITDA and/or substantially higher share of regulated and quasi-regulated activities in EBITDA structure.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Lease- and nuclear- adjusted FFO net leverage above 4.5x and/or corresponding fixed charge cover materially below 3.5x on a sustained basis.
- Falling wholesale power prices not compensated by conservative measures.
- Larger than expected investments and/or dividend payments.

LIQUIDITY
Fitch considers Vattenfall's liquidity position adequate for its rating. As of end-September 2015, Vattenfall had available liquidity in the form of cash and cash equivalents and short-term investments of SEK37bn and undrawn committed facilities of SEK19bn against short-term interest-bearing liabilities of SEK27bn.

FULL LIST OF RATING ACTIONS
Vattenfall AB
Long-term IDR downgraded to 'BBB+' from 'A-'; Outlook Stable
Senior unsecured rating downgraded to 'BBB+' from 'A-'
Subordinated capital securities of SEK3bn (fixed coupon), SEK3bn (floating coupon) and EUR1bn issued on 19 March 2015 rated 'BBB-'
Subordinated capital securities of USD400m issued on 19 November 2015 rated 'BBB-'.