Credit FAQ:

How Spain's Latest Electricity Reforms

Will Further Erode Utilities' Rating
Headroom
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Table Of Contents
Frequently Asked Questions
Related Criteria And Research
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Credit FAQ:
How Spain's Latest Electricity Reforms Will
Further Erode Utilities' Rating Headroom
In July 2013, the Spanish government announced additional measures to eliminate the Spanish electricity tariff deficit
that has burdened the Spanish electricity system since 2000. These new measures come on top of previous steps taken
by the government since 2012 that have adversely affected the profitability of power companies in Spain. The latest
reforms aim to eliminate the remaining 4.5 billion in annual tariff deficit accumulations for 2013. And the government
proposes that the burden be shared between the state budget (900 million), higher prices for consumers (900
million), and utilities and renewables electricity generators through lower remuneration (2.7 billion).
At this stage, there is insufficient detail in the announced measures for Standard & Poor's Ratings Services to complete
a full review of the effects of the proposals on rated power companies in Spain. But we believe that profitability and
rating headroom will be further eroded.
In this FAQ, we address some of the frequently asked questions from investors regarding how the latest measures
might affect the creditworthiness of rated utilities with significant exposure to the Spanish electricity market. We also
consider the likelihood of similar reforms occurring in the Spanish gas sector.
Frequently Asked Questions
What benefits and risks arise from the latest regulatory reforms for eliminating the Spanish electricity
tariff deficit, in Standard & Poor's view?
We believe that a permanent and structural resolution that eliminates the tariff deficit would greatly enhance visibility
in the sector and reduce energy policy uncertainty in Spain. That said, it's too early to conclude whether the reforms
announced in July can and will be implemented so that they successfully eliminate the tariff deficit. This is because a
significant share of the deficit is to be absorbed by the state budget in a period where Spain has a weak budgetary
position and the economy is undergoing prolonged structural adjustment. In addition, once details of certain elements
of the proposed measures--such as the remuneration framework for renewables generators--are made available, they
could end up being disputed in court by the utilities and renewables operators.
What were the electricity market reforms announced by the Spanish government in July?
The electricity sector reforms announced by the Spanish government in July comprise:
Changes in the regulatory framework and lower remuneration for electricity transmission and distribution network
owners;
A cut in the subsidies for renewable energy sources (RES);
Lower capacity payments for gas-fired power plants;
The re-introduction of a social benefit to vulnerable consumers;
Specification of the government's share in eliminating the tariff deficit;
An access tariff increase; and
The introduction of an annual automatic tariff adjustment mechanism.
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In addition, the reforms include recognition of the actual tariff deficit in 2012 and an extension of the state guarantee
that will allow its securitization. We continue to see uncertainties as to when the remaining outstanding electricity
deficit will be offloaded from utilities' balance sheets.
What are Standard & Poor's preliminary conclusions regarding the aforementioned reforms?
Although a significant proportion of the tariff deficit funding falls on Spanish vertically integrated utilities, we view
positively the continued commitment by the government to restore balance in the electricity sector in Spain. If and
when implemented, the reforms are likely to improve visibility on long-term profitability for Spanish utilities as
opposed to the piecemeal approach taken in the past, which has meant prolonged uncertainty for rated issuers. For
example, we note that the regulatory period for transmission and distribution will be extended to six years, reducing
uncertainty. In addition, the successful completion of the tariff deficit securitization program would mean that tariff
deficit debt-funding costs, which are a significant cost to the system, are eradicated and that utilities are no longer
reliant on the sovereign's ability to access the funding markets.
Does Standard & Poor's consider the announced measures sufficient to balance the revenues and
costs in the electricity system in Spain?
Yes. In our view, two factors will support the successful elimination of future tariff deficit accumulations and achieve a
balanced system. First, the introduction of an annual correction mechanism that's designed to prevent future large
imbalances by triggering automatic access tariff reviews should deviations exceed 2.5% of the estimated system
revenues for the year. Furthermore, we understand that any potential future system surpluses are to be used to finance
temporary tariff imbalances until there is an outstanding accrued deficit in the system. Any temporary tariff imbalances
will now be spread across all electricity system players (including renewable generators). It's also more likely, in our
view, that tariff surpluses will accrue if actual power demand exceeds forecasts. We base our view on the correlation of
electricity demand and economic growth, and the recovery in our forecasts of real GDP growth in Spain in the order of
0.6%-0.9% in the next two years. The fact that this mechanism is likely to be enshrined in law supports our view that
the system should remain balanced.
The second factor is the government's announcement that any future measure that results in an increase to system
costs or a decrease in revenues will need to be funded by an equivalent increase in revenues or decrease in costs for
the system. This supports our view of the government's recognition that the Spanish electricity sector needs not only
to balance in the near term, but also to be self-sufficient over the longer term.
Does Standard & Poor's believe the latest reforms eliminate electricity market uncertainty in Spain?
Not fully. As indicated above, if implemented, the July regulatory reforms could address the economic mismatches
between system revenues and costs. Nevertheless, the reforms do not eliminate political and regulatory risks, which
will continue to weigh on the business risk profiles of power companies and utilities with Spanish exposure. We believe
that the governments of countries affected by prolonged economic stress and facing stringent budgetary constraints,
such as Spain, are more prone to interfere negatively in cash flow-generative and socially important sectors such as
utilities. We believe this reduces operating and financial predictability for the utilities, especially since the Spanish
government retains the capacity to influence the tariff-setting process because the Ministry of Industry ultimately
approves any electricity tariff change.
Furthermore, the new regulatory measures could, in our view, lower the incentive for utilities to invest in the Spanish
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Credit FAQ: How Spain's Latest Electricity Reforms Will Further Erode Utilities' Rating Headroom
electricity sector over the longer term. We note, for example, that the government has slashed the remuneration for
networks under the latest reforms. Such remuneration is now based on the 10-year Spanish bond plus 100/200 basis
points (pre-tax) in 2013/2014.
It's also unclear whether or not the regulated asset base (RAB) of electricity transmission and distribution utilities will
be indexed to inflation. Should the RAB not be indexed for inflation, we believe RAB remuneration to be no higher
than 4.5% per year, which is near the cost of capital of the regulated utilities' businesses. In addition, new assets will
only be included in the RAB two years after completion.
As a result, we could lower our capital expenditure assumptions (to the extent these investments are not mandatory)
for the regulated electricity transmission and distribution networks. We are also of the opinion that the measures
introduced for renewable energy generators, based on the scant details available, represent a complete overhaul of the
remuneration system that will significantly reduce asset returns. (For more details, see "Spanish Energy Tariff Reforms
Could Hit the Renewables Sector Hard," published July 26, 2013, on RatingsDirect.)
Lastly, we believe the Spanish government has limited ability or intent to offer support for the financing of
extra-peninsular generation costs above the 900 million announced. This is only one-half of what we previously
expected. We also believe the government's ability to take on 900 million of the system costs on the annual state
budget could be restricted by future budgetary constraints.
What are the potential effects of the July reforms on rated utilities with Spanish operations?
We understand that the utilities have already assembled relatively reliable assessments of the effect of the July
announcements on their 2013-2014 earnings, with the exception of their renewables operations. Despite this, many
important details remain undisclosed about the regulation and remuneration of activities in the power sector in Spain.
This prevents us from being able to make a complete assessment of the effect of the proposed measures on future
earnings.
For example, the definition of the "implicit" RAB and indexation to inflation for regulated networks is unclear.
Moreover, the reduction in revenues for renewable electricity generation appears to depend on the technology and the
year of commissioning of the assets, but many details are still missing. Nevertheless, it's clear to us that the July
reforms will further erode the cash flows of the rated utilities. This is likely to reduce profitability, credit metrics, and
consequently rating headroom. We will evaluate the final effects of the reforms based on further details from the
government's decrees, which we expect to obtain over the next few months. Our evaluation will take into account any
potential counteractive cash-preserving actions by the utilities to mitigate the outcome of the reforms.
Rated issuers with exposure to Spanish operations in the electricity sector include Iberdrola S.A., Endesa S.A. (which
reflects the stand-alone credit profile of its Italy-based parent Enel SpA), Gas Natural SDG S.A., Red Electrica
Corporacion S.A., and EDP - Energias de Portugal S.A. Our base-case credit scenarios for these issuers already
incorporate our view of the negative effect on cash flow generation from measures introduced in Spain in 2012. We are
now integrating the information made available by our rated utility issuers on the likely impact of the July reforms into
our 2013-2014 forecasts. For Enel/Endesa, Iberdrola, and EDP, the full effect of the reforms remains uncertain
because these issuers have more material exposure to renewables in Spain.
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Credit FAQ: How Spain's Latest Electricity Reforms Will Further Erode Utilities' Rating Headroom
Our assessment arising from the 2012 reforms includes the delay with which generation taxes are fully passed through
in tariffs due to the inflexibility of supply contracts. We anticipate that market prices will reflect the additional tax
burden from 2014 onward, although this assumption might be challenged by the current market oversupply.
Looking ahead, we project the following effects of the latest reforms on our rated utilities:
Red Electrica. Spain's electricity transmission operator has comfortable headroom at the current rating level under our
forecast credit metrics for 2013-2014 . Our base-case scenario assumes a 6%-7% cut in transmission revenues from
2014 as a result of the latest reforms. This assumption aligns with Red Electrica's assessment that the reforms will lead
to a negative 100 million reduction in its revenues.
There is still a great deal of uncertainty regarding the definitive remuneration model beyond the transition period in
2014. Nevertheless, we believe Red Electrica is likely to maintain ample headroom at the current rating level to absorb
further adverse changes.
Gas Natural. We believe our rating on Gas Natural can withstand the negative impact of the proposed regulatory
measures that the company estimates for 2013-2014. This is because Gas Natural has relatively comfortable headroom
at the current rating level. The negative outlook on Gas Natural reflects our view of the company's high exposure to
country risk in Spain, considering that we forecast that more than 50% of its operating income will originate there
despite an acceleration in international investments.
Apart from a reduction in capacity payments for its gas-fired power plants, we anticipate that Gas Natural will be
affected by the considerable reduction in the remuneration for its electricity distribution operations, which accounted
for more than 10% of EBITDA in 2012. Moreover, the profitability of these assets could fall below the company's cost
of capital if the electricity distribution RAB is not indexed to inflation. Under such circumstances, our forecast of
gradually increasing cash flow from regulated activities in our base-case scenario would reduce. We also believe that
there will likely be a relatively small effect on Gas Natural's renewables business, due to its small share in Gas Natural's
generation portfolio.
Enel/Endesa. Based on Endesa's preliminary estimate, we believe that the immediate effect of the latest reforms on
Enel's credit metrics is manageable. Nevertheless, Endesa was already significantly affected by the regulatory decisions
taken in 2012. Moreover, the government's proposed revision of the remuneration for renewables generation in Spain
would affect the group's Enel Green Power business, although the impact is likely to be marginal in light of the ongoing
growth of the group and its high degree of diversification.
EDP. Our base-case scenario for EDP assumes a low-single-digit decline in EBITDA in 2013 and mid-single-digit
EBITDA growth in 2014. Excluding the cut in renewables' remuneration, and in the absence of sufficient details,
management assesses the effect of the reforms to be negative 19 million in 2013 and negative 36 million in 2014.
Management has revised upward its EBITDA target for full-year 2013, with guidance of low-single-digit growth (from
flat EBITDA previously). This suggests to us that EDP has some headroom to absorb the adverse effects of the reforms
and should be able to maintain credit metrics in line with our expectations.
Iberdrola. We believe that Iberdrola can manage with its publicly announced estimate of a reduction in revenues of
about 170 million in 2013 and 260 million in 2014 (excluding renewables generation) while maintaining metrics in
line with our rating guideline of Standard & Poor's-adjusted funds from operations to debt of 18%. This is because
Iberdrola has reduced leverage and built some headroom into its credit ratios, following recent tranches of tariff deficit
securitization and asset disposals. In addition, the group's international diversification, in particular the strong
performance of its U.S. and U.K. regulated operations, provides a partial shield to the ongoing tough market conditions
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Credit FAQ: How Spain's Latest Electricity Reforms Will Further Erode Utilities' Rating Headroom
in Spain. We will reassess the group's estimates when more clarity emerges about the effect of the latest reforms on
renewables generation, particularly in respect of 2013 metrics where headroom is tighter.
Does Standard & Poor's consider that an equally comprehensive review of Spanish gas distribution
and transmission is likely?
At this stage, we do not anticipate any contagion from the announced reforms in the electricity sector spreading to the
Spanish gas sector. This is because the accumulated tariff deficit in the gas sector is much smaller (an estimated peak
in 2016 of less than 900 million, compared with an accumulated electricity tariff deficit of 28 billion as of year-end
2012) and is not structural. It results from rising system costs at a time of falling demand due to the economic cycle
and weather effects. We anticipate that fixed costs will stabilize in the future because no new gas infrastructure is
planned and conventional demand is increasing, which should reduce the economic imbalance between regulated
costs and access fees.
Moreover, the gas market in Spain is less mature (gas penetration in Spain is lower than the European average). As a
result, the remuneration for gas distribution provides a clear incentive for increasing penetration and consumption
levels, which in turn should support the overall economic balance of the system.
Related Criteria And Research
The articles listed below are available on RatingsDirect.
Spanish Energy Tariff Reforms Could Hit The Renewables Sector Hard, July 26, 2013
What's Behind Our Rating Actions On Spanish Power Utilities?, April 4, 2012
How The Spanish Electricity Tariff Deficit And Political Uncertainties May Affect The Ratings On Spanish Utilities,
Jan. 12, 2012
Additional Contact:
Infrastructure Finance Ratings Europe; InfrastructureEurope@standardandpoors.com
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Credit FAQ: How Spain's Latest Electricity Reforms Will Further Erode Utilities' Rating Headroom
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