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Rating Action:

Moody's affirms Baa1 ratings of the UK gas distribution networks

07 Mar 2013

Outlook on Wales & West Utilities Finance plc's Baa1 ratings changed to negative from stable

London, 07 March 2013 -- Moody's Investors Service has today affirmed the Baa1 senior unsecured ratings of Northern Gas Networks Ltd (Northern), Scotland Gas Networks plc (Scotland) and Southern Gas Networks plc (Southern) following their acceptance of new price controls imposed by the UK energy regulator, Ofgem, in December 2012. The outlook on all ratings is stable. Moody's has also today affirmed the Baa1 ratings assigned to GBP450 million of senior secured bonds of Wales & West Utilities Finance plc (WWUF), a subsidiary of Wales & West Utilities Limited (WWU), but has changed the outlook to negative from stable.

The new price controls, known as RIIO-GD1, specify the amount of revenue that the regulated gas distribution networks (GDNs) are able to recover from customers over the eight-year period April 2013 to March 2021.

RATINGS RATIONALE

--- AFFIRMATION OF Baa1 RATINGS FOR NORTHERN, SCOTLAND AND SOUTHERN

The affirmation of the Baa1 ratings of Northern, Scotland and Southern reflects (1) the evolutionary nature of the changes in Ofgem's new RIIO methodology; (2) allowed regulatory returns that are in line with Moody's expectations; (3) projected financial metrics for the three companies that are in line with Moody's guidance for the current ratings; and (4) above-average ranking of the three companies in Ofgem's efficiency assessment of the eight UK GDNs' submitted business plans.

RIIO refers to the formula Revenue = Incentives + Innovation + Outputs and the revised regulatory framework has been used by Ofgem to set prices for the GDNs as well as the electricity and gas transmission companies. Key features of the new regime include an extended price control period of eight years rather than five, the use of a trailing average debt index to set allowed returns, enhanced incentives and penalties and a drive to increase companies' stakeholder engagement.

The allowed weighted average cost of capital (WACC) is a key credit consideration. In this regard, the move by Ofgem to link the return on debt to a trailing average of a specific bond index is a significant development for RIIO-GD1. For the first year of the price control, the return on debt is 2.92% (pre-tax, real), 63 basis points (bps) lower than is currently allowed. For the other WACC parameters, Ofgem has retained the values published at Initial Proposals, i.e., a 6.7% (post-tax, real) return on equity (vs. 7.25% in the current control) and a notional gearing assumption of 65% debt/regulatory asset value, or RAV (vs. 62.5% in the current control). Combined with the trailing average approach to the return on debt, this translates into a 'vanilla' WACC of 4.2% in 2013/14. Going forward, with real yields currently lower than the trailing average it is likely that the latter will continue falling. This is important as for the first time the allowed return on debt (and thus allowed revenue) will not be fixed for the length of the price control and will move in line with the trailing average.

Over the eight years of RIIO-GD1, the GDNs are required to deliver a number of regulatory outputs in return for their GBP14.4 billion of allowed expenditure, particularly in the areas of safety, the environment and customer service. In Moody's view, the nature of the allowed expenditure is very much in line with the existing price control for the GDNs. The results of Ofgem's cost assessment reveal that of the eight UK GDNs' submitted business plans, the regulator considered Northern's to be the most efficient, with allowances cut by only 4% versus that submitted. As a combined group, Scotland and Southern were judged to be in second place, with allowances cut by around 5% compared to those submitted.

--- STABLE OUTLOOK FOR NORTHERN, SCOTLAND AND SOUTHERN

The stable outlook on the Baa1 ratings of Northern, Scotland and Southern reflects (1) Moody's expectation that the companies' operational and financial performance will be broadly in line with the regulator's assumptions; (2) Moody's expectation that the companies will manage their dividend distributions as necessary in order to maintain a level of leverage commensurate with the assigned Baa1 ratings.

--- CHANGE OF OUTLOOK TO NEGATIVE ON Baa1 RATINGS OF WWUF's SENIOR SECURED BONDS

The change of outlook on the Baa1 ratings of WWUF's senior secured bonds to negative from stable reflects the additional risks associated with its highly-leveraged financial structure and the likelihood that the company will exhibit over the near-to-medium term an adjusted interest coverage lower than Moody's expectation for the assigned Baa1 rating.

While the terms of WWU's highly-leveraged financial structure are similar to those of other regulated UK utilities, Moody's rating of the two Class A bonds is one notch lower at Baa1 principally due to the company's additional risk exposure under certain index-linked swap arrangements. In this regard, as at 31 March 2012 WWU had around GBP1 billion of index-linked swaps, equivalent to around 50% of the company's RAV. Furthermore, the mark-to-market on these swaps was more than GBP600 million at the last reporting date.

Moody's estimates that WWU's adjusted interest cover ratio (ICR) will average around 1.2x in the initial years of RIIO-GD1, when the accretion under the index-linked swaps is taken into consideration. While this level is somewhat lower than Moody's guidance for a typical UK GDN Baa1 rating, WWU's Class A senior secured bonds that are rated by Moody's benefit from the presence of subordinated Class B debt, equivalent to around 10% of the total. Nevertheless, the negative outlook reflects the potential for the adjusted ICR to fall below 1.2x, should real bond yields remain at current levels. If so, the calculated allowed return will also fall, exerting further downward pressure and leaving WWU dependent on outperformance to meet Moody's ratio guidance. The rating agency believes that this will be challenging for WWU given the company's ranking in Ofgem's efficiency assessment. The company ranked seventh (out of eight) in Ofgem's benchmarking of the eight GDNs' submitted business plans and incurred a 16% cut from the regulator vs. the submitted business plan, of which 7% was due to differences in future efficiency.

Moody's believes that the outlook could be stabilised if WWU is able to achieve consistent outperformance of its regulatory settlement or if the risks associated with its financial structure are reduced. Moody's notes that since September 2012, WWU is now owned by a consortium headed by Cheung Kong Infrastructure Holdings Limited, a group who has demonstrated a track record of prudent financial policy and solid operating performance in their holdings of other UK regulated assets, including the ownership of Northern.

WHAT COULD CHANGE THE RATING UP/DOWN

---NORTHERN GAS NETWORKS LTD

Moody's sees little potential for upward pressure as ratings assume that Northern may use over time its current financial flexibility to increase leverage. However, a sustained reduction in leverage could lead to upwards rating pressure.

Conversely, poor operating performance or a change in the group's financial policy, resulting in a net debt to RAV ratio above 75% or an adjusted ICR below 1.4x without any prospect of near-term recovery would not be consistent with the current rating.

---SCOTLAND GAS NETWORKS PLC

Moody's sees little potential for upward pressure given the group's current financial policy of maintaining its leverage close to 75%. Conversely, poor operating performance or a change in the group's financial policy, resulting in a net debt to RAV ratio above 75% or an adjusted ICR below 1.4x without any prospect of near-term recovery would not be consistent with the current rating.

---SOUTHERN GAS NETWORKS PLC

Moody's sees little potential for upward pressure given the group's current financial policy of maintaining its leverage close to 75%. Conversely, poor operating performance or a change in the group's financial policy, resulting in a net debt to RAV ratio above 75% or an adjusted ICR below 1.4x without any prospect of near-term recovery would not be consistent with the current rating.

--- WALES & WEST UTILITIES FINANCE PLC

Moody's sees no potential for upward pressure on the ratings assigned to WWUF's senior secured bonds given the group's current highly leveraged structure and negative outlook. Ratings could be downgraded if the adjusted ICR remains below 1.2x with no expectation for a recovery.

PRINCIPAL METHODOLOGY

The principal methodology used in rating Northern Gas Networks Ltd, Scotland Gas Networks plc, Southern Gas Networks plc and Wales & West Utilities Finance plc was the rating methodology for Regulated Electric and Gas Networks, published in August 2009. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

Northern Gas Networks Ltd is one of eight regulated gas distribution networks responsible for the supply of gas to 2.7 million customers through 37,000 kilometres of gas pipelines in the north of England. Northern Gas Networks Ltd is a wholly-owned subsidiary of Northern Gas Networks Holdings Ltd, a holding company owned by a consortium headed by Cheung Kong Infrastructure Holdings Limited.

Headquartered in Horley, Scotland Gas Networks plc and Southern Gas Networks plc are two regionally distinct gas distribution networks operating in Scotland and the South of England, respectively. Both companies are wholly-owned subsidiaries of Scotia Gas Networks Ltd, a holding company owned by a consortium including Scottish and Southern Energy plc, Borealis Infrastructure Europe (UK) Ltd and Ontario Teachers' Pension Plan Board Investments (UK) Ltd.

Incorporated in England and Wales, Wales & West Utilities Finance plc is a 100%-owned financing subsidiary of Wales & West Utilities Limited. Wales & West Utilities Limited is owned by a consortium headed by Cheung Kong Infrastructure Holdings Limited.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt 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 rating action on the support provider and in relation to each particular 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 rating action, and whose ratings may change as a result of this 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.

This rated entity (Wales & West Utilities Finance plc) or its agent(s) did not participate in the rating process. Moody's was not provided, for purposes of the rating, access to books, records and other relevant internal documents of the rated entity.

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.

Scott Michael Phillips
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
SUBSCRIBERS: 44 20 7772 5454

Monica Merli
MD - Infrastructure Finance
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 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
SUBSCRIBERS: 44 20 7772 5454

Moody's affirms Baa1 ratings of the UK gas distribution networks
No Related Data.
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