OREANDA-NEWS. Fitch Ratings has revised the Outlook on Northern Powergrid Holdings Company's (NPG) Long-term Issuer Default Rating (IDR) to Stable from Negative. Fitch has affirmed the Long-term IDR at 'BBB+', senior unsecured rating at 'A-' and Short-term IDR at 'F2'. The agency has simultaneously affirmed the group's two distribution network operating businesses (DNOs), Northern Powergrid (Northeast) Limited's (NPN) and Northern Powergrid (Yorkshire) plc's (NPY) Long-term IDRs at 'A-', senior unsecured ratings at 'A', and Short-term IDRs at 'F2'. The Outlooks have been revised to Stable from Negative. A full list of rating actions is at the end of this release.

The revision of the Outlooks reflects our increased comfort that the companies will comply with our ratio guidance during the new price control, RIIO-ED1 (ED1). This is because the companies demonstrated solid incentive performance in the first nine months of the new price control as well as reduced the average cost of debt by successfully raising GBP350m of debt at low fixed rates. Additional return over and above the regulatory allowances together with lower cost of debt support stronger forecast post maintenance interest cover ratios (PMICRs). The affirmation is supported by the group's conservative financing structure and low business risk.

KEY RATING DRIVERS
Lower Return Expected in ED1
The new ED1 price control, which will run from April 2015 until March 2023, is stricter than the preceding DPCR5. The allowed return on regulatory equity (RORE), cost of debt and total expenditure are lower than in DPCR5. They are also more difficult to outperform. The regulator shifted part of the remuneration from the cost of capital into incentives, which led to an increasing impact of operational performance on the financial profile.

NPN and NPY have earned a RORE of around 11.8% (real, post-tax) versus the baseline allowance of 6.7% in DPCR5. We estimate that NPG's achieved RORE could go down by as much as 20% during ED1 versus DPCR5, excluding the RPI impact, due to the combination of tougher output targets and lower allowances in the ED1 final determinations.

Outperformance Driven by the Interruptions Incentive
We expect major outperformances to come from the Interruptions Incentive Scheme (IIS). The group expects to earn around GBP66m of additional revenue in ED1 (GBP25m in NPN and GBP41m in NPY, in 12/13 prices), which is a conservative estimate given the strong performance to date. Should the first year's performance continue consistently, there is potential to increase additional revenue by 60%.

We conservatively embed zero total expenditure (totex) outperformance in our forecast, although we recognise that the companies' track records suggest additional earnings could be achieved. In DPCR5, NPG achieved around 7% total expenditure outperformance. Although ED1 allowances are around 4% lower than actual expenditure in DPCR5, there is still scope to deliver low single digit savings. The group plans to re-invest all of the outperformance to drive output improvement.

Fitch's rating case incorporates only marginal income from the customer satisfaction incentive. Although NPG significantly improved its customer service in DPCR5, it is still performing below the industry average and close to the minimum regulatory target.

Cost of Debt Underperformance
NPG has a policy of raising exclusively fixed rate debt. Although at the time of borrowing the cost of debt was incurred efficiently, the group's average cost of debt compares unfavourably with the 10-year average iboxx index (basis for Ofgem's cost of debt allowance). This is because the company's cost of debt adjusts very slowly to the changes in real interest rates and inflation. A fixed rate debt structure could be beneficial if interest rates and inflation go up. However, at present it is disadvantageous due to a fall in real rates and inflation.

We expect NPG to underperform versus Ofgem's cost of debt allowances at least in the first half of ED1. Further performance depends on the direction of rates and inflation. The group's most expensive bonds mature in 2020, and we think there could be an opportunity for outperformance afterwards. The recently raised GBP350m of new debt financing at a low 2.5%-2.6% positions the group well for outperformance in the second half of the price control, if rates go up.

Financial Profiles Commensurate with Ratings
Fitch estimates PMICR to be around 1.6x for NPG, 1.8x for both NPN and NPY (eight-year average over the price control period) versus the negative rating sensitivities of 1.6x for NPG and 1.9x for the operating companies. Net debt/RAV is expected to average 61% for NPG, 50% for NPN and 51% for NPY, which is solid and well within our ratio guidance of 75% for the group and 60% for the operating companies. Fitch notes that due to a financial covenant in the GBP200m holding company bond maturing in 2022, the group can only raise debt if its consolidated senior net debt to RAV does not exceed 65%.

Although NPN's and NPY's interest cover ratios are slightly below our downgrade guidance of 1.9x, we deem their financial profiles commensurate with 'A-' IDRs due to very conservative gearing and a number of potential upsides not captured by our rating case. These include higher IIS income and above zero totex outperformance. Additionally, we take into account the group's intention to reduce dividend distributions to the level assumed by Ofgem (5% of the notional equity portion of RAV) for as long as the entity's interest coverage ratio remains under pressure versus our negative guidance.

NPN and NPY are very sensitive to changes in real rates and inflation due to their fully fixed rate debt structure. For example, we estimate that a 1% decrease in long-run RPI would result in 0.1x lower 8-year average PMICRs. Persistently low real interest rates would pressurise PMICRs.

Supportive Shareholder
Fitch incorporates supportiveness of the shareholder and relaxed dividend policy into NPG's rating. NPG is fully owned by Berkshire Hathaway Energy Company (BHEC, BBB+/Stable), which is in turn 90%-owned by Berkshire Hathaway Inc (AA-/Stable). BHEC owns a broad portfolio of energy companies and takes a long-term view of its investments. NPG has paid limited dividends since 2003. Some dividend distributions are planned for the next three years which would bring the capital structure in line with Ofgem's assumptions, but there is flexibility around this.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- RPI of 1.3% for FY16, 2.3% for FY17 and 3.1% flat thereafter, in line with HM Treasury's forecasts for the UK economy (used by Ofgem)
- Average allowed cost of debt under Ofgem's IBOXX trombone mechanism of 2.45% in ED1
- Average cost of debt for the eight-year price control is 5.6% for NPG, 5.5% for NPN and 5.0% for NPY
- Total incentive revenue in ED1 is assumed at around GBP37m for NPN and GBP53m for NPY (in 12/13 prices)
- Zero totex outperformance
- Customer rebate recovery of GBP16m for NPN and GBP14m for NPY in FY16 (in 12/13 prices)
- Revenue under-recovered in the previous price control of GBP20m for NPN and GBP13m for NPY to be recovered in FY17 (corrected for two-year inflation)
- Annual EBITDA from unregulated activities of GBP16m for NPG
- All other information regarding revenue allowances mirrors Ofgem's final determinations

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:

Rating upside is limited if management maintains a capital structure not materially deviating from the regulator's 65% notional gearing.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- NPG: leverage (net debt/RAV) above 75% and PMICR falling materially below 1.6x, both on a sustained basis.
- NPN and NPY: Weak regulatory and operational performance or increase in dividends that adversely affect the cash flow position, taking net debt/RAV above 60% and PMICR materially below 1.9x, both on a sustained basis.

The agency is unlikely to downgrade the ratings of the various group companies for interest cover marginally below guidelines, as long as gearing continues to be at materially lower levels in comparison with the applicable guidelines.

LIQUIDITY
As of December 2015, the group held GBP58m in cash and cash equivalents and had a committed revolving credit facility of GBP150m with maturity in April 2020 and GBP42m overdraft facility. None of the facilities has been drawn. This funding position provides liquidity for all operating and capital requirements until the end of 2017. The next large bond maturity is in 2020: NPN's GBP100m bonds and NPY's GBP200m bonds.

FULL LIST OF RATING ACTIONS

NPG:
Long-term IDR: affirmed at 'BBB+'; Outlook revised to Stable from Negative
Senior unsecured rating: affirmed at 'A-'
Short-term IDR: affirmed at 'F2'

Yorkshire Power Group Limited:
Long-term IDR: affirmed at 'BBB+'; Outlook revised to Stable from Negative
Short-term IDR: affirmed at 'F2'
Yorkshire Power Finance Ltd:
Senior unsecured notes affirmed at 'A-', guaranteed by Yorkshire Power Group Limited

Yorkshire Electricity Group plc:
Long-term IDR: affirmed at 'BBB+'; Outlook revised to Stable from Negative
Short-term IDR: affirmed at 'F2'

Northern Electric plc:
Long-term IDR: affirmed at 'BBB+'; Outlook revised to Stable from Negative
Short-term IDR: affirmed at 'F2'

NPN:
Long-term IDR: affirmed at 'A-'; Outlook revised to Stable from Negative
Short-term IDR: affirmed at 'F2'

Northern Electric Finance Plc:
Senior unsecured notes: affirmed at 'A'; guaranteed by NPN

NPY:
Long-term IDR: affirmed at 'A-'; Outlook revised to Stable from Negative
Senior unsecured rating: affirmed at 'A'
Short-term IDR: affirmed at 'F2'