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Rating Action:

Moody's changes outlook on Southern Gas Networks and Scotland Gas Networks ratings to negative

29 Jan 2019

London, 29 January 2019 -- Moody's Investors Service ("Moody's") has today changed to negative from stable its outlook on the Baa1 senior unsecured and backed senior unsecured ratings and (P)Baa1 senior unsecured programme ratings of Southern Gas Networks plc and Scotland Gas Networks plc (Scotland GN and Southern GN), two Gas Distribution Networks (GDNs) and the principal operating companies of the Scotia Gas Networks group. Concurrently, Moody's has affirmed the companies' ratings and taken no action on the backed A2 ratings.

The driver for today's rating action is a methodology consultation published by Ofgem, the industry regulator, in December 2018, which signals a sharp cut in allowed returns and reduced scope for financial outperformance in the RIIO-GD2 period that begins in April 2021. Although Ofgem is consulting on mechanisms to support companies in the event of financial distress, this is unlikely to provide support to Scotland GN and Southern GN at the current rating levels.

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

RATINGS RATIONALE

RATIONALE FOR THE NEGATIVE OUTLOOK

The negative outlooks reflect the risk that interest cover for Southern GN and Scotland GN will fall below Moody's guidance for the current rating level in the RIIO-GD2 regulatory period that starts in April 2021.

The SGN group's exposure to the reduction in returns and opportunities for outperformance signalled by Ofgem is increased by the high gearing of the SGN group, relative to Ofgem's working assumption, including additional debt at SGN MidCo Limited (SGN MidCo) and shareholder loans at Scotia Gas Networks Limited (SGN HoldCo). Although considerable uncertainty remains about the regulatory allowed return for RIIO-GD2, there is significant risk that, absent offsetting measures, Moody's adjusted interest cover ratios (AICRs) will fall below guidance for the current rating of at least 1.4x at Scotland GN and Southern GN and 1.2x at the consolidated SGN MidCo group.

Although both operating companies have significantly outperformed regulatory assumptions in the current period, Ofgem proposes to constrain outperformance by the sector in general and to make targets for individual companies more challenging.

In RIIO-GD2, Ofgem intends to adopt a structurally lower measure of inflation, the Consumer Prices Index including owner occupiers' housing costs (CPIH), in place of the Retail Prices Index (RPI). This change to the indexation of companies' revenues and Regulatory Asset Value (RAV) will increase cash flows over the medium term, partially offsetting the expected reduction in underlying allowed returns, but will also create a mismatch between regulatory asset growth and SGN's portfolio of RPI-linked debt. This mismatch is likely to mean that the companies' regulatory assets inflate more slowly than these debt instruments over time, and could lead to increases in net debt/RAV in years when the RPI-CPIH wedge is wider than expected.

RATIONALE FOR AFFIRMATION OF THE RATINGS

Moody's decision to affirm the Baa1 ratings reflects the companies' low business risk as the monopoly providers of gas distribution services in Scotland and the South of England, the well-established and transparent regulatory regime, and the companies' strong performance against all regulatory outputs in the first five years of the current price control, which runs until March 2021. Affirmation of the ratings also takes into account that the regulatory review for RIIO-GD2 is still in progress and key decisions remain outstanding, including on allowed returns, and that management and shareholders may act to maintain credit quality in the new regulatory period.

WHAT COULD CHANGE THE RATING UP/DOWN

The outlooks could be stabilised if further regulatory decisions make it likely that expected returns, including reasonably probable operational outperformance, will support interest coverage metrics consistent with the assigned rating. The outlook could also be stabilised if the SGN group took measures to strengthen its balance sheet and/or materially reduce financing costs.

The ratings could be downgraded if announcements by Ofgem further increase the likelihood that Southern GN and Scotland GN will receive a regulatory settlement that will not support interest coverage ratios consistent with the assigned rating and the reduction in allowed returns appears unlikely to be offset by management action.

Downward rating pressure could be exacerbated by debt at SGN HoldCo in an extended period of weak cash flows, given the absence of a meaningful interest coverage covenant at SGN MidCo.

Adjusted interest cover ratio guidance for the current rating of at least 1.4x at Southern GN and Scotland GN and 1.2x at SGN MidCo may be revised as Ofgem's price review progresses. Any revision will take into account factors including any changes in Moody's assessment of the stability and predictability of the regulatory framework, potential revenue volatility for companies and the incremental basis risk resulting from the change in indexation of Scotland GN's revenues as compared to its liabilities.

The principal methodology used in these ratings was Regulated Electric and Gas Networks published in March 2017. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

LIST OF AFFECTED RATINGS

Affirmations:

..Issuer: Scotland Gas Networks plc

.... LT Issuer, Affirmed Baa1

....Senior Unsecured MTN Program, Affirmed (P)Baa1

....Backed Senior Unsecured MTN Program, Affirmed (P)Baa1

....Underlying Senior Unsecured MTN 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

..Issuer: Southern Gas Networks plc

....LT Issuer Rating, Affirmed Baa1

....Senior Unsecured MTN Program, Affirmed (P)Baa1

....Backed Senior Unsecured MTN Program, Affirmed (P)Baa1

....Underlying Senior Unsecured MTN 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:

..Issuer: Scotland Gas Networks plc

....Outlook, Changed To Negative From Stable

..Issuer: Southern Gas Networks plc

....Outlook, Changed To Negative From Stable

Southern GN is the largest of the eight GDNs in England, Wales and Scotland by RAV, providing 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 GDNs and provides gas distribution services to around 1.8 million customers through around 25,000 kilometres of gas pipelines in Scotland. As of 31 March 2018, Southern GN had a RAV of GBP3.8 billion and Scotland GN had a RAV of GBP1.7 billion.

Both companies are wholly owned subsidiaries of SGN MidCo, which also owns SGN Natural Gas Limited, a company that is developing a gas network in the west of Northern Ireland. SGN MidCo is a subsidiary of SGN HoldCo, which is in turn owned by a consortium including SSE plc (Baa1 stable), OMERS, the Ontario Teachers' Pension Plan Board (Aa1 stable) and the Abu Dhabi Investment Authority.

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 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.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

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.

Graham Taylor
VP - Senior Credit Officer
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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