OREANDA-NEWS. Fitch Rating says that there is no immediate rating impact on Energa S.A. (Energa, BBB/Stable) and PGE Polska Grupa Energetyczna S.A. (PGE, BBB+/Stable) related to their potential investment in coal mining group Polska Grupa Gornicza Sp. z o.o. (PGG). The investment should be neutral for their ratings due to large rating headroom and expected risk mitigating factors. However, the departure from original investment plans is marginally negative for Energa and increased exposure to or integration with mining would weaken Energa's and to a lesser extent PGE's business profile.

Together with power and heat producer PGNiG Termika S.A., Energa and PGE have submitted non-binding conditional offers to provide capital to PGG, which will operate 11 hard coal mines contributed in kind by Kompania Weglowa S.A., a state-owned coal mining company in financial distress. The capital injection needed by PGG will be around PLN1.5bn, of which Energa has declared an investment of up to PLN600m and PGE of up to PLN500m.

The size of the declared investment in PGG is high for Energa, constituting 27% of the company's EBITDA in 2015. Furthermore, Energa's generation from and demand for coal remain low (2.4TWh and 1.2MT in 2015, respectively), which raises questions about the strategic reasoning of the investment. This could change if Energa decides to reinstate the project to construct a new hard coal-fired block in Ostroleka, which was frozen in 2012. This in turn would considerably raise overall investment and increase exposure to the generation segment, which is also under pressure. More details on Energa's revised strategic approach should become available with its corporate strategy update in 2Q16.

For PGE, the declared investment is relatively low (6% of 2015 EBITDA) and largely matched with its generation business, for which hard coal is the number two fuel (11.9TWh of power production and 5.6MT of hard coal purchased in 2015).

Fitch perceives coal mining as a higher risk sector than power generation and much higher than regulated distribution or transmission. This is partially driven by its exposure to volatile hard coal prices with a relatively high fixed cost base for most Polish mines leading to high operating leverage. Consequently, acquisitions of mining assets by utilities lead to a deterioration of utilities' credit risk profile. This can be mitigated, for example by well-matched production and demand volumes (actual and effective vertical integration) between the acquirer and the target and low cost base or good asset quality of the target.

Despite increased exposure to mining, especially for Energa, if the transaction is finalised, we currently do not anticipate negative rating action as both companies have large headroom in their ratings. We currently expect average funds from operations (FFO) adjusted net leverage in 2015-2017 to reach around 2.5x for Energa and around 1.5x for PGE (with negative rating guideline at 3.5x for Energa and 3.0x for PGE). However, we note that the investment could have negative implications on ratings if it further weakens credit metrics or leads to underinvestment in generation and distribution.

We currently assume that Energa's investment in PGG will be accompanied by a reduction in its voluntary capex (for instance for wind farms or combined heat and power plants), which it could easily cut back. For PGE the amount of investment is not material compared with total capex. We also expect that the preconditions for binding offers announced by Energa and PGE will be met. These include in particular implementation of restructuring activities guaranteeing profitability of PGG business with no further capital increases within the next 10 years. Should these conditions not be met, Energa and PGE's credit metrics could be negatively impacted, which in turn may lead to negative rating action.

Negative rating action could be triggered also by further investments, acquisitions of interests or other forms of support for remaining coal mining companies, leading to excess leverage, weaker business profile or delays of core capex in generation or distribution at the cost of mining.