Electricity North West Limited -- Moody's changes outlook on Electricity North West to stable; affirms ratings

Rating Action: Moody's changes outlook on Electricity North West to stable; affirms ratingsGlobal Credit Research - 31 Mar 2021 London, 31 March 2021 -- Moody's Investors Service (Moody's) has today changed the outlook for Electricity North West Limited (ENWL) and ENW Finance plc (ENW) to stable from negative. Concurrently, Moody's has affirmed the Baa1 senior unsecured ratings of ENWL and the Baa1 and (P)Baa1 (medium term note program) backed senior unsecured ratings of ENW. The drivers for today's rating action are (1) Moody's expectation that ENWL will maintain strong operational performance over the remainder of the current regulatory period, which will support the company's financial profile through March 2025; and (2) the regulator signaling in March 2021 a higher cash cost of debt allowance in the next regulatory period, a reversal of its prior position. RATINGS RATIONALERATIONALE FOR THE STABLE OUTLOOK The stable outlook reflects Moody's expectation that ENWL will maintain financial metrics commensurate with the current Baa1 rating level through financial year ending March 2025 despite high embedded debt costs relative to peers and regulatory assumptions. Moody's expects ENWL to maintain an adjusted interest coverage ratio (AICR) of between 1.4x and 1.9x (excluding timing differences) over FY2021-25, above minimum guidance for the Baa1 rating level of 1.4x. Over FY2021-23, and the remainder of the current regulatory period -- RIIO-ED1, Moody's expects ENWL to deliver strong operational performance both against regulatory cost allowances and financial output delivery incentives. The rating agency projects this will contribute around 0.6x per annum to ENWL's AICR over this period with most of this coming from output delivery incentives (ODIs). ODIs are highly powered in electricity distribution, particularly on network reliability and to a lesser extent customer service, and earnt incentive income is paid with a two-year lag. Following a material (further) improvement in network reliability in the most recent regulatory year (2019-20), customer interruptions and customer minutes lost fell by 17% and 18% respectively, Moody's expects ENWL to cap out on earnt incentive income (GBP11 million, post-tax, per annum in 2012/13 prices) under the scheme over FY2022-23 despite the annual tightening of regulatory targets. This, in conjunction, with the greatest improvement on customer satisfaction survey scores in RIIO-ED1 to-date of all electricity distribution groups, albeit from the lowest base, means Moody's forecasts ENWL's earnt incentive income will increase over the remainder of RIIO-ED1 and also support AICR metrics by over 0.4x in the first two years of RIIO-ED2. Regulatory data shows that ENWL have spent around 5% below controllable cost allowances over the first five years of RIIO-ED1. ENWL expects the level of outperformance to be materially higher in the final three years of RIIO-ED1 (averaging over GBP20 million per annum in 2012/13 prices, or 8.8%), bringing the overall level for RIIO-ED1 to 6.8%. This reflects that ENWL believes it can now meet regulatory risk point delivery targets at lower cost, through optimization of its planned investment programme, whilst still meeting regulatory targets (it was previously forecasting over-delivery on risk points over RIIO-ED1). ENWL can keep over half (58%) of these savings, which will provide around 0.2x of benefit to AICR. ENWL's regulator, Ofgem, has set much tougher regulatory cost allowances for the RIIO-2 controls that start in April 2021 (transmission and gas distribution) and proposed, in July 2020, that there would be a material cut in cash allowed returns for electricity distributions in RIIO-ED2, which will commence in April 2023. However, in the finance annex of its sector specific methodology decision published in March 2021 [1], Ofgem has asked the electricity distribution companies to assume that cash allowed returns will, on average, be around current levels (c. 3%). The c. 0.4% increase in allowed returns was primarily driven by a significantly higher cost of debt allowance than for other subsectors, a reversal from its initial view, but in keeping with the approach for most electricity distribution groups (including Electricity North West) in RIIO-ED1. Notwithstanding credit positive developments on allowed returns in RIIO-ED2, with potential further upside if transmission and gas distribution companies are successful in challenging the size of Ofgem's cuts to allowed equity returns, ENWL's rating remains constrained by its high embedded debt costs. These are largely attributable to the 8.875% bonds (totaling GBP450 million) due in March 2026, which comprised over 35% of ENWL's net debt at March 2020. Moody's anticipates, however, that the long-standing mismatch between ENWL's borrowing costs and the cost of debt allowance will persist even once this bond is refinanced, as ENWL has indexed linked swaps which will generate material cash outflows until 2038. Moody's estimates the net interest expense (including accretion of principal) of the swaps maturing in 2038 will average over GBP20 million per annum in RIIO-ED2. This is around a third of the rating agency's projections for ENWL's interest expense over this period. Consequently, absent (1) further improvements in key regulatory parameters for RIIO-ED2; or (2) operational outperformance in RIIO-ED2, we expect ENWL to have limited, if any, headroom to minimum ratio guidance for the Baa1 rating over the final three years of RIIO-ED2. Moody's considers the ENWL's immediate parent company - North West Electricity Networks plc (NWEN MidCo) -- has even less headroom against minimum guidance (1.2x) over this period due to the material incremental debt at this level - typically around 20% of ENWL's regulatory asset value (RAV). However, with (1) draft and final determinations for RIIO-ED2 not expected until mid- and late-2022; (2) the scope for material earnt ODI income in RIIO-ED2; and (3) interest expense significantly impacted by the cost of refinancing the March 2026 bonds, the position could change in the intervening period. RATIONALE FOR AFFIRMATION OF THE RATINGS Moody's decision to affirm ENWL's Baa1 rating reflects a number of continuing credit strengths, including the company's monopoly position as holder of the licence to provide electricity distribution services in the north-west of England, the low business risk of distribution activities, the well-established and transparent regulatory regime and management's track record of excellent operational performance under the current price control, which runs until March 2023. FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS Upward pressure on the ratings is unlikely to arise given (1) the materially higher leverage of NWEN MidCo level; and (2) Moody's expectation that ENWL's and NWEN's AICR will weaken in the final three years of RIIO-ED2 when earnt ODI income from RIIO-ED1 ceases to be received. Downward pressure on the ratings would arise if following regulatory determinations for RIIO-ED2, expected in mid- and late-2022, either ENWL or NWEN were not expected to maintain an AICR of at least 1.4x and 1.2x over RIIO-ED2, in particular over the final three years. Downward rating pressure would arise if either ENWL's or NWEN's net debt to RAV were expected to exceed 75% or 85% respectively, though Moody's considers this eventually unlikely. The principal methodology used in these ratings was Regulated Electric and Gas Networks published in March 2017 and available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1059225. Alternatively, please see the Rating Methodologies page on www.moodys.com for a copy of this methodology. ENWL, a wholly-owned subsidiary of NWEN, is the monopoly provider of electricity distribution services to around 2.4 million premises in an area covering 12,500 square kilometres in the north-west of England. ENWL is one of the fourteen electricity distribution network operators (DNOs) in Great Britain regulated by the Office of Gas and Electricity markets (Ofgem), and the smallest group operator of electricity distribution assets in the United Kingdom (UK) as measured by RAV of GBP1.9 billion at March 2020. ENWL is owned 40% by KDM Power Limited, a consortium led by Kansai Electric Power Company, Incorporated (A3 negative); 40% by Equitix managed funds; and 20% by an investment vehicle controlled by CNIC Corporation Limited. REGULATORY DISCLOSURES For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004. For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. 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The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.These ratings are solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website www.moodys.com.Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review. Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1243406. The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody's affiliates outside the EU and is endorsed by Moody's Deutschland GmbH, An der Welle 5, Frankfurt am Main 60322, Germany, in accordance with Art.4 paragraph 3 of the Regulation (EC) No 1060/2009 on Credit Rating Agencies. Further information on the EU endorsement status and on the Moody's office that issued the credit rating is available on www.moodys.com. REFERENCES/CITATIONS[1]https://www.ofgem.gov.uk/system/files/docs/2021/02/final_determinations_-_finance_annex_revised_002.pdfPlease see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating. Philip Cope Asst Vice President - Analyst Infrastructure Finance Group Moody's Investors Service Ltd. One Canada Square Canary Wharf London E14 5FA United Kingdom JOURNALISTS: 44 20 7772 5456 Client Service: 44 20 7772 5454 Neil Griffiths-Lambeth Associate Managing Director Infrastructure Finance Group JOURNALISTS: 44 20 7772 5456 Client Service: 44 20 7772 5454 Releasing Office: Moody's Investors Service Ltd. 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