OREANDA-NEWS. Fitch Ratings has affirmed SSE plc's Long-Term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook. Fitch has also affirmed SSE's senior unsecured debt rating at 'BBB+', Short-Term IDR and Short-term senior unsecured rating for commercial paper programme at 'F2' and subordinated notes, including all outstanding hybrid issuance, at 'BBB-'.

The 'BBB+' IDR reflects SSE's largely regulated, hedged cash flow profile. Regulatory visibility has improved in networks and supply, while conventional generation may become more regulated in future. However, these improvements are offset by increased regulatory uncertainty in renewables and a possible second referendum on Scottish independence. SSE has an inflexible capital structure and gearing headroom for the rating is limited.

KEY RATING DRIVERS

Regulated, Hedged Cash Flow Profile

SSE's cash flow is highly regulated, with networks and quasi-regulated renewables representing 46% and 26%, respectively, of EBITDA. SSE is the only UK company with a presence in electricity transmission, electricity distribution and gas distribution. Regulatory asset value (RAV) is almost GBP8bn, rising to nearly GBP10bn by 2020, and currently split 29% electricity transmission, 40% electricity distribution and 31% gas distribution. Conventional generation earnings are set to become less sensitive to commodity prices due to an increase in ancillary services and, from October 2017, capacity payments.

SSE faces commodity exposure as a competitor in electricity & gas supply markets. However, renewables provide a hedge against a rise in power prices while growing regulated earnings offset the impact of low power prices.

Improved Regulatory Visibility in Networks

Regulatory risk has reduced and cash flow visibility in regulated networks has improved due to a strong operating and regulatory performance in the first year of ED-1 price control (April 2015-2023). Other contributing factors are a negligible impact from the Competition and Markets Authority's (CMA) appeal of the RIIO-ED1 price control in electricity distribution and no mid-term review in electricity transmission and gas distribution.

As capex on networks accounts for 52% of total, SSE is well placed to increase RAV, supporting a higher notional debt capacity, to around GBP10bn by 2020. The likely partial sale of part of the 50% SGN stake underlines SSE's financial flexibility in this respect. However, this would also reduce the share of regulated activities and it may be premature to give the senior unsecured rating the single-notch uplift Fitch typically applies to regulated networks with 50% or more of EBITDA from regulated activities.

Renewables Increasing Uncertainty Longer Term

Although spark and dark spreads look stronger this winter, UK baseload forwards remain depressed and there are signs that conventional generation earnings may become more regulated in future. UK government energy policy continues to make progress, notably with respect to the generation capacity market.

However, SSE faces longer-term uncertainty with respect to the level and support of renewable technologies from the new government; renewables represent 95% of SSE's generation EBITDA. Also, following the EU referendum vote, it remains to be seen whether Scotland holds a second referendum for independence. Scotland accounts for 32% of SSE's generation capacity, 12% of retail customers and 51% of RAV.

Supply Margins Peaking

Retail supply earnings were higher-than-expected in the financial year to March 2016, contributing 18% to SSE's EBITDA. However, we expect this share to fall because, following a major drop in commodity prices last year, gas supply margins rose to levels substantially above the long-term average. With 44 suppliers (versus 25 two years ago), competitive pressures remain and the new cap on prepayment meters will have an impact on the financials. As electricity tariffs may be due for a rise, supply may again attract unwanted political attention. However, for the first time since 2013, this business benefits from better visibility following the conclusion of the CMA's investigation into the UK energy market.

Limited Financial Flexibility

Financial flexibility is limited, due to the commitment to grow dividends by at least RPI, a now complete asset disposal programme (except potentially a minority stake in SGN), and 75% of capex already committed through to FY20. This limited flexibility also applies to the capital structure, where hybrids account for 27% of total and where the company's September 2012 EUR750m and USD700m issues are due for discretionary redemption and fixed-rate reset in October 2017.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for SSE include:

-Recurring exceptional items of GBP500m in FY17 and GBP250m in FY18

-Capex in line with company's guidance, but no allowance for any further acquisitions of upstream reserves over the long term

-Dividend growth at RPI of 1.5% pa & 20% scrip take-up, consistent with previously and peers.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- Expected funds from operations (FFO) adjusted net leverage of 4.0x (FY16: 4.3x) and FFO fixed charge cover of 4.5x (FY16: 4.0x), on a sustained basis.

-Regulated EBITDA contributing to above half of the company's total, which may lead to the debt ratings being upgraded by one notch. Fitch typically notches up debt ratings of regulated networks due to our assumption of higher recovery prospects.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- Negative regulatory change, potentially in renewables

- Expected FFO adjusted net leverage of more than 4.5x and FFO fixed charge cover below 3.5x on a sustained basis.

LIQUIDITY

As at 31 March 2016, SSE had cash & cash equivalents of GBP360m plus committed undrawn lending facilities of GBP1.5bn, maturing in 2020, GBP150m of uncommitted bank lines and a GBP15m overdraft facility. The company pre-refinanced GBP700m of term loans due in FY17, with the issue of the GBP500m US private placement and a GBP300m loan from the EIB. The latter was drawn as a fixed-rate term loan in May 2016.

Fitch estimates negative free cash flow of GBP589m for FY17. However, SSE has a policy of accessing debt markets to ensure that it has available committed borrowing and facilities equal to at least 105% of forecast borrowings over a six-monthly rolling period and liquidity is adequate until at least September 2017.