Scope Ratings has today published its final rating methodology for European utilities, with no changes compared to the proposed methodology published on 29 September 2015 other than minor editorial changes. This follows the ‘call for comments’ period from 29 September 2015 to 30 October 2015, during which no comments were received from external market participants.

The methodology supplements Scope’s corporate rating methodology, which was updated on 11 November 2015. It applies to companies that collect the majority of their total revenue and cash flows through the generation, storage, transmission and/or distribution of electricity, heat and/or gas from facilities it owns and/or operates. The sector criteria cover a wide range of utilities from large pan-European incumbents with a high degree of vertical integration to small municipal utilities (‘Stadtwerke’) and independent power producers. Independent power producers which concentrate on the production of renewable energy are covered by Scope’s rating methodology “European Renewable Energy Corporates”.

“Scope’s rating approach on European utilities applies to both regulated and unregulated utility segments,” says Sebastian Zank, industry expert on Scope’s corporate rating team. “Utilities tend to display high leverage and long amortisation profiles due to the capital intensiveness of operated assets. Due to different cash flow patterns of regulated downstream activities (transmission and distribution) and non-regulated upstream activities (power generation), Scope applies different thresholds for key credit metrics when rating utilities.” When analysing essential credit metrics, Scope shows its unique approach on pension provisions, which are very common in the utilities industry, and reflects the long-term nature of such provisions.

Parameters which qualify a utility for an investment grade rating are: strong cash flow protection with low substitution risk through stable regulation and strong market position across different service territories; a well-diversified asset and customer base anchored strongly in noncyclical business segments; solid profitability patterns with low volatility; highly predictable cash flows; and sound financial metrics. Strong government support from a financially strong sovereign or sub-sovereign reduces the likelihood of a utility’s corporate default and can improve a utility’s credit rating to the higher investment grade categories.

In contrast, high merchant and substitution risks due to challenging or unstable regulations or government interference, a comparatively small and less diversified asset portfolio that is vulnerable to event risks, a strong cyclical exposure in power generation, exploration or supply can be indicators for a sub-investment grade rating. Other indicators of a utility’s credit quality in the sub-investment grade bracket are high exposure to loss-making infrastructure segments, such as public baths or public transport that require continuous financial support or cross-subsidising from other activities. Such business risks may be coupled with less predictable and volatile cash flows in conjunction with weaker financial measures that also indicate a sub-investment grade rating.

Ratings of utilities can reach up to higher investment grade categories, driven mostly by the degree of business protection, which may stem from a supportive and stable regulatory environment or a monopolistic market position, a very well-diversified geographic footprint or a strong link to potential government support in case of a bail-out.

Scope does not expect this new rating methodology to impact its existing ratings.

The ‘Rating Methodology - European Utilities’ is available on www.scoperatings.com.