OREANDA-NEWS. Fitch Ratings has affirmed Melton Renewable Energy UK PLC (MRE UK)'s Long-term Issuer Default Rating (IDR) at 'BB' with Stable Outlook and senior secured notes at 'BB'.

The affirmation reflects Fitch's expectations of positive free cash flow generation, supported by dividend covenants restricting net debt/ EBITDA to 3.25x. However, the company's size is limited and last year's removal of the Climate Change Levy (CCL) exemption for renewable generators and, in particular, lower UK wholesale power prices will have a negative impact on EBITDA. Although MRE UK has an option to redeem up to 10% of the senior secured notes by February 2017, these factors will affect the cash build and capacity to refinance the GBP171m bond due in 2020. Accordingly, faster deleveraging is necessary to reduce refinancing risk and maintain the rating.

KEY RATING DRIVERS
Largely Supportive UK Regulation
Approximately 47% of MRE UK's revenues benefit from the renewables obligation incentive scheme. The government has confirmed its commitment to safeguarding existing incentive schemes and we assume revenues will continue to receive the same level of support until 2027. The majority of the group's support revenues, renewables obligation certificates (ROC) Buy-Out, are indexed to inflation. The smaller element, ROC Re-cycle, should increase as long as the UK's renewable obligation (set by Department of Energy and Climate Change annually) increases at a faster rate than the increase in volume of renewable electricity generated. The government announced last July its intention to discontinue the CCL exemption for renewable electricity from August 2015. The move was unexpected and the impact will be to lower revenues and EBITDA of around GBP4.5m or 10% in FY17.

Power Price Exposure
Around 41% of revenues are exposed to power prices. This could lead to price volatility and have a substantial impact on cash flows and the rating. Weak gas prices, coal prices and demand have meant further continued weakness in UK wholesale baseload electricity prices. Although MRE UK fixes its electricity selling price up to 12 months forward for biomass output (currently up to September 2016) and up to six months forward for landfill gas output (currently to March 2016), these are only short-term hedges. Latest forward electricity prices indicate low GBP30s per MWh through FY20, versus around GBP50 previously. For every GBP1 fall in the power price, EBITDA falls by around GBP1m.

Declining Output Based on Landfill
For landfill gas, which accounts for 35% of EBITDA, Fitch expects output to show a gradual continuous decline of around 4% pa. For the six months to September 2015, landfill gas output was 173 GWh, a decrease of 7.7% year-on-year, as a result of a general reduction in output from its closed sites and gas collection issues at two large sites, Whinney Hill & Cathkin, due to high leachate and delays in getting gas infrastructure deployed. At the group level, we expect the decline in landfill to be largely offset by good availability and output from biomass in FY16.

Refinancing Risk
The GBP171m bond matures in February 2020. Lower wholesale prices add risk to the refinancing process. However, MRE UK redeemed 10% of the senior secured notes at a cost of GBP19m in August 2015. It has an option to pay down a further 10% at any time between February 2016 and February 2017, potentially lowering debt to GBP154m. Given that regulatory change was a trigger for the August 2015 repayment, we believe that the fall in wholesale prices may have a similar effect. We would therefore expect the company to proceed with a further bond redemption, lowering refinancing risk. However, MRE UK currently has no such plans but will keep this under review.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for MRE UK include:
- In view of slight shortfalls for FY14 & FY15 and expected difficulties in landfill in FY16, slightly lower output figures from FY17.
- Substantially lower UK baseload forwards versus previous expectations. These are currently in the low GBP30's (winter GBP45/MWh, summer GBP33/MWh FY17, winter and summer low thirties from FY18).
- Biomass output is sold forward at GBP43.40 until September 2016, landfill at an average GBP43.60/MWh until March 2016. After these dates, output is sold at UK forwards above, with a substantial impact on EBITDA.
- Dividends are assumed at the highest level permitted by a covenant that prevents net debt/EBITDA increasing above 3.25x prior to the date that is three years from the bond issue and 2.5x thereafter.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to positive rating action include:
- Increased wholesale electricity prices or output above Fitch's expectations leading to FFO gross adjusted leverage sustainably below 2.5x and FFO gross interest cover sustainably above 4.0x.

Future developments that may, individually or collectively, lead to negative rating action include:
- Lower wholesale electricity prices or output below Fitch's expectations leading to FFO adjusted net leverage sustainably above 4.0x and FFO gross interest cover sustainably below 2.5x.
- Any further changes to the regulatory framework with a material impact on profitability and cash flow.

LIQUIDITY
MRE UK's cash position in September 2015 was GBP10.9m. Following the partial redemption of the senior secured bond in August 2015, the company's debt comprises GBP171m senior secured notes due February 2020 and a subordinated shareholder loan of GBP126.1m. We excluded the shareholder loan, which is subordinated to all current and future indebtedness of the company and due to be repaid no earlier than February 2021, from the Restricted Group's IDR perimeter in our analysis. MRE UK also has access to the GBP20m RCF due in 2019. In view of moderately low capex and working capital requirements, we expect MRE UK to be substantially free cash flow positive.