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Rating Action:

Moody's affirms Baa1 ratings of Scotland Gas Networks and Southern Gas Networks; maintains negative outlook

23 Apr 2021

London, 23 April 2021 -- Moody's Investors Service (Moody's) has today affirmed the Baa1 senior unsecured and long-term issuer ratings, and (P)Baa1 senior unsecured programme ratings of Scotland Gas Networks plc and Southern Gas Networks plc (Scotland GN and Southern GN), two gas distribution networks (GDNs) and the principal operating companies of the Scotia Gas Networks (SGN) group. Moody's has taken no action on the companies' backed A2 ratings. The outlook remains negative.

The rating action follows the February 2021 publication by energy regulator Ofgem of its corrected final determinations for the five-year RIIO-GD2 regulatory period that commenced on 1 April 2021.

A full list of affected ratings is provided towards the end of this press release.

RATINGS RATIONALE

RATIONALE FOR NEGATIVE OUTLOOK

Moody's decision to maintain the negative outlook on Scotland GN and Southern GN reflects its expectation that both companies will exhibit financial metrics over the RIIO-GD2 period below levels commensurate with the Baa1 rating level if they perform in line with regulatory determination, as it currently stands, absent measures to bolster credit quality.

Under this scenario, Moody's expects Scotland GN to maintain an average adjusted interest coverage ratio (AICR) during RIIO-GD2 of 1.35-1.4x (excluding timing differences which will materially support metrics in financial year ending March 2023), slightly below the rating agency's minimum guidance for the Baa1 rating level of 1.4x. Over the same period, and on the same basis, Moody's expects Southern GN to exhibit an AICR of around 1.3x. Moody's believes the difference is attributable to higher cash embedded debt costs at Southern GN, primarily attributable to lower levels of inflation linked debt in its capital structure (c. 17%) than at Scotland GN (c. 31%, the regulatory assumption is 30%), which results in a lower base return (regulatory return divided by interest expense).

Both companies interest coverage metrics are depressed by higher leverage, as measured by net debt to regulatory asset value (RAV), than other energy networks and regulatory assumptions. During the prior regulatory period, RIIO-GD1, Scotland GN and Southern GN maintained net debt to RAV in the low 70s in percentage terms and Moody's does not expect any material changes in RIIO-GD2, where the regulatory assumption is 60% (65% in the prior regulatory period, RIIO-GD1). In RIIO-GD1, pressure on interest coverage metrics was offset by strong operational performance, particularly against regulatory costs allowances where outperformance averaged 15% across both networks , which boosted achieved equity returns by almost 5% at Scotland GN and 4% at Southern GN . However, in RIIO-GD2 regulatory return is slightly lower, due to the large cuts in lower allowed equity returns, and Moody's considers the scope for operational outperformance is limited.

Ofgem's regulatory cost allowances for RIIO-GD2 assume ongoing annual productivity gains averaging 1.2%, significantly above the levels in prior regulatory determinations for UK regulated utilities primarily due to the regulator incorporating an additional innovation challenge (0.2%) in its computation. These high levels of assumed annual productivity gains, deductions in regulatory cost allowances due to the regulator's cost efficiency benchmarking process and the introduction of a tougher benchmarking standard, means Moody's anticipates that the scope for material cost outperformance is limited.

Similarly, Ofgem has set significantly more demanding regulatory targets on output delivery incentives carrying financial rewards or penalties (ODI-Fs) (albeit smaller than in RIIO-GD1) and altered the calibration to reduce reward opportunities on customer satisfaction survey and shrinkage incentives, in RIIO-GD2. However, Scotland GN and Southern GN operating cash flows in FY2022 and FY2023 will continue to benefit from incentive income earnt in RIIO-GD1 as the rewards are paid with a two-year lag, benefiting AICR by around 0.1x and 0.2x for the companies respectively in these years .

Like all the incumbent gas distribution and transmission networks, SGN (on behalf of Scotland GN and Southern GN) has lodged several technical appeals on aspects of its regulatory determination where it believes the regulator has made a clear and material error. The Competition and Markets Authority (CMA) agreed on 31 March to review all the aspects that SGN sought permission to appeal and will make its final decision by 30 October. Since other aspects of the regulatory determination cannot be revisited as part of the CMA's review, and based on the CMA's final decision for the four UK water companies that successfully appealed aspects of their recent regulatory determination, Moody's consider there is negligible downside risk and potentially modest upside for RIIO-GD2. There may also be greater benefit in future regulatory periods due to the precedent set. A reduction in the size of the cut in allowed equity returns would increase base returns while higher regulatory cost allowances would increase the scope for modest operational outperformance.

RATIONALE FOR RATING AFFIRMATION

Affirmation of the Baa1 ratings reflects the companies' low business risk as the monopoly providers of gas distribution services in Scotland and the south of England, which in Great Britain operate under a well-established and transparent regulatory regime. Affirmation of the ratings also factors in the comparatively small gap to meet minimum Baa1 guidance, particularly for Scotland GN, and Moody's expectation that SGN will take steps to defend credit quality as required . Moody's anticipates that any measures which put creditors interests ahead of SGN's shareholders and that are costly to reverse will only be implemented after the results of the pending appeal are known.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

The outlooks could change to stable if it appeared likely that the CMA's determination would support interest coverage metrics consistent with the assigned rating (at least 1.4x). The outlooks could also change to stable if the SGN group took measures to strengthen its balance sheet and/or materially reduce financing costs.

The ratings could be downgraded if (1) the CMA rejected SGN's appeals ; (2) Moody's considered SGN was unlikely to take measures to protect both companies credit quality in a timely manner thereafter; and (3) for Scotland GN, due to the small gap to minimum AICR guidance, modest operational outperformance appeared unlikely to arise.

The ratings could also be downgraded if (1) net debt to RAV rose above 75%; or (2) a more aggressive financial policy was pursued at the companies' immediate parent company, SGN MidCo Limited (SGN MidCo), such that either net debt to RAV rose above 85% or AICR fell below 1.2x. Moody's does not anticipate a change in financial policy at SGN MidCo and expects the company to exhibit net debt to RAV around 80% and an AICR of 1.3x over RIIO-GD2 under the current regulatory determination and group financial policy.

LIST OF AFFECTED RATINGS

Issuer: Scotland Gas Networks plc

..Affirmations:

....LT Issuer Rating, Affirmed Baa1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)Baa1

....Senior Unsecured Regular Bond/Debenture, Affirmed Baa1

....Underlying Senior Unsecured Regular Bond/Debenture, Affirmed Baa1

..Outlook Actions:

....Outlook, Remains Negative

Issuer: Southern Gas Networks plc

..Affirmations:

....LT Issuer Rating, Affirmed Baa1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)Baa1

....Senior Unsecured Regular Bond/Debenture, Affirmed Baa1

....Backed Senior Unsecured Regular Bond/Debenture, Affirmed Baa1

....Underlying Senior Unsecured Regular Bond/Debenture, Affirmed Baa1

..Outlook Actions:

....Outlook, Remains Negative

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.

Southern GN is the largest of the eight GDNs in Great Britain. It provides gas distribution services to around 4.0 million customers through about 49,000 kilometres of gas pipelines in the South of England, including the cities of Milton Keynes and Dover, and London boroughs south of the River Thames. Scotland GN is the second smallest of the eight GDNs by RAV. It provides gas distribution services to around 1.8 million customers through around 25,000 kilometres of gas pipelines in Scotland. As of 31 March 2021, Southern GN had a regulatory RAV of GBP4.1 billion and Scotland GN had a regulatory RAV of GBP1.8 billion.

Both GDNs are wholly owned subsidiary of Scotia Gas Networks Limited (SGN HoldCo) via the intermediate holding companies SGN MidCo and SGN PledgeCo Limited. SGN HoldCo is, in turn, owned by a consortium including SSE plc (Baa1 negative), OMERS Administration Corporation (Aa1 negative), Ontario Teachers' Pension Plan Board (Aa1 stable) and the Abu Dhabi Investment Authority.

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. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

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.

Please 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.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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