Fitch Affirms Poland's PGE at 'BBB+'; Outlook Stable
The affirmation is driven by PGE's strong market position in the Polish electricity sector and a current conservative financial profile. The ratings are constrained by Fitch's expectation of declining margins in conventional generation, PGE's core business unit, the fairly low share of the regulated network business in PGE's EBITDA, and large capex plans. Capex will increase funds from operations (FFO) adjusted net leverage to about 2x in 2017 and about 3x in 2020 from 0.3x in 2015, largely eliminating headroom within current ratings.
KEY RATING DRIVERS
Strong Market Position
The ratings reflect PGE's strong position in the power generation segment in Poland and lower-than-average electricity production costs. The company has a favourable place in the merit order, due to the lower cost of lignite versus coal, a generally modern generation fleet and the largest market share in generation (about 37%) in Poland.
The ratings are constrained by PGE's limited diversification of generation sources and high average carbon dioxide (CO2) emissions per MWh, due to reliance on lignite and hard coal, compared with most other Fitch-rated European utilities.
Decreasing Margins on Coal/Lignite-Fired Generation
Fitch expects PGE's generation segment to come under increasing cash flow pressure from lower wholesale power prices in Poland as well as rising costs of CO2. The latter is in particular a challenge for lignite-fired generation due to its higher CO2 emissivity. This will be mitigated by the fairly limited openness of the Polish wholesale power market, compared with some more interconnected markets in Europe, and the right to receive part of CO2 allowances free of charge at least until 2020.
Future cash flows in generation will no longer be supported by compensation payments given that 2016 is the last year of the compensation scheme for the termination of PGE's long-term power purchase agreements. In the long term, erosion of margins in conventional generation would create a systemic threat for the restoration of generation fleet. However, this may improve if the government's plan to introduce a power capacity market in Poland is implemented. We currently do not assume any payments related to the potential capacity market in our rating case for PGE, apart from the existing limited support mechanisms in the form of the operational capacity reserve and interventional cold reserve.
Investments in Hard Coal Mining
In April 2016 PGE, together with Energa S. A. (BBB/Stable), PGNiG S. A. and Weglokoks S. A. signed an investment agreement to acquire shares in Polska Grupa Gornicza Sp. z o. o. (PGG), a new company established to restructure Kompania Weglowa, a state-owned mining company in financial difficulties. PGE's total investment in PGG (17.1% of share capital) amounts to PLN500m over 2016-2017, which corresponds to 6% of 2015 EBITDA of PGE.
Fitch treats coal mining as a higher-risk sector than power generation and much higher than regulated distribution or transmission. This is largely driven by its exposure to volatile hard coal prices with a fairly high fixed cost base for most Polish mines, leading to high operating leverage. As the scale of PGE's investment in PGG is limited compared with total capex, it has limited impact on PGE's overall credit risk profile. However, further investments or acquisitions of hard coal mines could have negative implications for PGE's credit and business profiles.
Lower WACC in Distribution
The reduction of weighted average cost of capital (WACC) for power distribution to 5.7% in 2016 from 6.8% (incorporating a 5% haircut to regulated profit applied by the regulator) in 2015 has a negative impact on PGE's power distribution business, reducing EBITDA by close to PLN0.3bn. Despite the reduction, Fitch treats power distribution as PGE's most stable business. Due to ongoing capex in distribution as well as expected decrease in power generation results, we forecast distribution's share in PGE's EBITDA to exceed 40% within the next two to three years, up from around 30% in 2015.
Conservative Financial Profile
PGE is among the least indebted European utilities rated by Fitch, with close to zero net leverage at end-2015. However, PGE has also a high exposure to the challenging conventional power generation sector (57% of 2015 EBITDA) and a low share of more predictable, regulated income from distribution compared with its Polish and European peers.
Large Capex to Increase Leverage
Fitch projects FFO adjusted net leverage to increase to about 2x in 2017 and about 3x in 2020 from 0.3x in 2015, due to projected negative free cash flow (FCF) driven by large capex. We view net leverage of 3x as the maximum for the ratings.
PGE's ambitious capex plan includes two new hard coal power blocks in Opole of 0.9GW each and a new lignite block in Turow of 0.5GW. The new blocks should be commissioned in 2018-2020 and improve efficiency and result in lower CO2 emissivity. We do not expect any major projects in renewable generation due to a less favourable regulatory framework (shift from green certificates to auctions) as well as recent additional legal and technical requirements to construct and operate wind farms. PGE's project company is conducting some preparatory works ahead of the construction of a nuclear power plant (3GW), but expected large capex for a nuclear power plant is beyond our five-year rating horizon.
Rated on Standalone Basis
PGE is 57%-owned by the Polish state (A-/Stable), but Fitch rates it on a standalone basis because we assess legal, operational and strategic links with the state as moderate based on our Parent and Subsidiary Rating Linkage criteria.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for PGE include:
- Wholesale electricity prices at around PLN150 per MWh for 2018-2020
- Hard coal prices ranging between PLN250 and PLN280 per tonne over the rating horizon
- CO2 market price increasing by 50% between 2016 and 2020
- Increased electricity production volumes from 2018-2020, due to commissioning of new conventional blocks in Opole and Turow
- Investment in PGG not exceeding the announced PLN500m as well as disposal of Exatel by 2018
- WACC in the distribution segment at 5.7% in 2016, gradually increasing to 6% in 2019
- Capex of about PLN30bn in 2016-2020
RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Recovery of EBITDA in conventional generation, for example due to the introduction of a capacity market in Poland or an increase in budget of existing capacity mechanisms, which could translate into stronger projected credit metrics. Projected FFO adjusted net leverage below 2x on a sustained basis, supported by management's more conservative leverage target, which could be positive for the ratings.
- A more diversified fuel generation mix and lower CO2 emissions per MWh, which together with planned efficiency improvements, would result in a stronger business profile.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Deterioration of credit ratios, including FFO adjusted net leverage above 3x and FFO fixed charge cover below 5x on a sustained basis, for example due to significant and persistent fall in wholesale electricity prices or generation volumes.
- Further acquisitions of stakes in coal mines, other form of support for state-owned mining companies under financial pressure, or excess capex for mining leading to net leverage above 3x or substantially worsening PGE's business profile.
LIQUIDITY
We view PGE's liquidity as sufficient. At end-March 2016, PGE had PLN1.2bn of unrestricted cash and cash equivalents as well as PLN5.5bn of committed unused facilities against short-term debt of PLN0.3bn and Fitch-projected negative FCF of about PLN3bn for 2016. In 2Q16 a further PLN5.5bn of committed unused facilities from a syndicated loan became available. PGE plans to substantially increase its debt in the next five years to co-fund the capex plan.
FULL LIST OF RATING ACTIONS
PGE Polska Grupa Energetyczna S. A.
Long-Term Foreign and Local Currency IDRs affirmed at 'BBB+'; Outlook Stable
Foreign and local currency senior unsecured ratings affirmed at 'BBB+'
National Long-Term Rating affirmed at 'AA(pol)'; Outlook Stable
National senior unsecured rating affirmed at 'AA(pol)'
PGE Sweden AB (publ), guaranteed by PGE Polska Grupa Energetyczna S. A.
Foreign currency senior unsecured rating affirmed at 'BBB+'
Foreign currency senior unsecured expected rating of 'BBB+(EXP)' withdrawn. Fitch has withdrawn PGE Sweden AB (publ)'s expected senior unsecured rating because it is no longer expected to convert to final ratings. This is due to the cancellation of the planned issue.
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