Fitch Downgrades NIE's Senior Unsecured Rating to 'BBB+'

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June 5 (Reuters) - (The following statement was released by the rating agency)

Fitch Ratings has downgraded Northern Ireland Electricity Limited's (NIE) senior unsecured rating to 'BBB+' from 'A-' and removed it from Rating Watch Negative (RWN). The GBP400m notes due 2026 issued by NIE Finance plc have also been downgraded to 'BBB+' from 'A-' and removed from RWN. Fitch has also affirmed NIE's Long-term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook. A full list of rating actions for NIE and its subsidiaries is at the end of this commentary.

The downgrade of the senior unsecured ratings reflect the Final Determination (FD) 'Transmission and Distribution Price Controls 2012-2017' (RP5) for NIE as published by the Competition and Markets Authority (CMA; formerly the Competition Commission), on 15 April 2014. We consider the FD is tougher than previous price controls, resulting in a weaker standalone credit profile for NIE, which is commensurate with a 'BBB' IDR. The affirmation of NIE's Long-term IDR with a Stable Outlook reflect the company's ties to its ultimate parent Electricity Supply Board (ESB; BBB+/Stable; senior unsecured BBB+).

KEY RATING DRIVERS

Challenging Price Control Determination

Although the CMA has slightly increased capital and operational expenditure (capex and opex) allowances in the FD, these have been offset by reductions in other items such as the pension deficit repair allowances, resulting in the same absolute amount of allowed regulated revenues compared with the provisional determination.

The CMA has introduced significant changes to NIE's price control, including separate price controls for the company's transmission and distribution networks, separate allowances for direct capex and indirect costs based on the Office for Gas and Electricity Markets (Ofgem) precedent, including benchmarking of indirect costs using GB distribution network operators as comparators, and a 50:50 cost risk-sharing mechanism for capex and opex in respect of differences between the allowed costs and NIE's actual costs. The CMA has set revenue allowances for a price control period of 5.5 years from 1 April 2012 to 30 September 2017 and has also put in place arrangements to return to either consumers or NIE any differences in the CMA's proposed revenue allowances for the period from 1 April 2012 to October 2014 and the tariffs that have already been set for that period.

The lower cost of capital of 4.1% is comparable to the cost of capital applied by other regulators in the UK in recent price controls. However, combined with the lack of any incentive revenue available to NIE, it is expected to have a negative impact on the company's allowed revenues and consequently its cash flow generation ability. We expect the reduction in cash flow generation, mainly driven by the lower regulatory allowed revenues, will negatively affect NIE's adjusted post-maintenance and post-tax interest cover ratio (PMICR) as calculated by Fitch and limit the company's financial flexibility.

Weaker Credit Profile

Fitch forecasts PMICR at around 1.3x (average of 2012-2017) and leverage (net debt to regulatory asset value or RAV) slightly below 50% towards the end of the price control. However, forecast PMICR ratios are expected to be lower than 1.3x for the remainder of the price control due to expected over-recoveries of revenue arising from the difference between revenue allowances set for 1 April 2012 to October 2014 and the tariffs that have already been set. These forecasts are based on the FD's allowed regulated revenues, the company's assumptions for capex, which include a number of additional investments related to transmission reinforcement and renewables, that are expected to be approved by the regulator on a project-by-project basis, and most importantly, no dividend distributions. It also includes additional pension deficit repair shortfall payments compared with the regulatory allowance.

While forecast leverage places NIE in a strong position compared with Fitch's guidance for similarly rated UK distribution network operators, the forecast reduced PMICR in isolation indicates the lower end of investment grade. Fitch notes that leverage can often be directly influenced by management through the choice of dividend policy while PMICR is a less manageable credit metric.

We also believe that the substantial changes introduced in the price control, and the uncertainties surrounding the implementation of those changes by NIE are likely to increase the operating risks faced by the company. Although the FD has resulted in some alignment between the regulatory frameworks in the UK and that of NIE, we view the regulatory environment in Northern Ireland as not as well established and less predictable than those for regulated utilities in other parts of the UK.

Rating Alignment with ESB

NIE's IDR and the Stable Outlook reflect the ties to its ultimate parent, ESB, including full ownership, liquidity support by ESB and back-to-back interest rate swap arrangements entered into by the two companies in April 2011. NIE's senior unsecured rating is now equal to that of ESB, while NIE's IDR remains unchanged at 'BBB+' due to the parent's support.

RATING SENSITIVITIES

Negative: Future (Other OTC: FRNWF - news) developments that could lead to negative rating action include:

- A downgrade of ESB.

- A further weakening in NIE's standalone profile, such as leverage (net adjusted debt/regulatory asset base) above 57.5% and/or PMICR below 1.2x, both on a sustained basis, together with weaker links with ESB.

Positive: Future developments that could lead to positive rating actions include:

- A positive rating action on ESB. An upgrade of ESB's IDR could lead to an upgrade of NIE's IDR and senior unsecured ratings as long as links with ESB remain strong. An upgrade of ESB's senior unsecured rating as a result of an upgrade of Ireland (Other OTC: IRLD - news) would not lead to an upgrade of NIE's senior unsecured rating.

- A positive rating action on NIE's senior unsecured rating , although unlikely for the forecast horizon to 2017, would be considered if the company cash flow generation improved significantly leading to PMICR above 1.4x and leverage (net adjusted debt/regulatory asset base) remained below 57.5%, both on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE

As at 31 December 2013, NIE had GBP32m in cash and cash equivalents and undrawn committed revolving credit facilities of GBP60m maturing in 2015, which are provided by ESB. This is sufficient to cover short-term operating requirements. The company's next debt maturity is due in 2018.

FULL LIST OF RATING ACTIONS

Northern Ireland Electricity Limited

-Long-term IDR affirmed at 'BBB+'; Outlook Stable

-Senior unsecured downgraded to 'BBB+' from 'A-'; off RWN

NIE Finance plc

-Senior unsecured rating downgraded to 'BBB+' from 'A-'; off RWN