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Thu 16 Oct 2008 04:00 AM

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Emerging market utilities: The track ahead

Eugene Korovin, an associate director at Standard & Poor's Ratings Services, discusses the challenges facing EEMEA utilities in the short-to-medium term.

Eugene Korovin, an associate director at Standard & Poor's Ratings Services, discusses the challenges facing EEMEA utilities in the short-to-medium term.

Since October 2007, the overall rating performance of utilities within the emerging markets has been positive. Currently, 14 of the 22 utilities in Standard & Poor's Eastern Europe, Middle East, and Africa (EEMEA) portfolio have achieved the investment grade rating of ‘BBB-' or above, including the four rated utilities in the Middle Eastern region.

Within this period there have been four upgrades across the sector and no downgrades. Furthermore, in three of the four upgrades, the relevant utility company was raised from speculative to investment grade.

Nevertheless, there are still significant challenges being faced by a number of companies in our portfolio, which may put pressure on the ratings in the short to medium term. Indeed, since October 2007, there have been several downward outlook revisions and CreditWatch placements with negative implications, which tilt the overall balance of rating outlooks to negative.

Current challenges

Certainly, the weakening macroeconomic environment in many countries of the region presents short-term challenges to credit quality. In fact, Saudi Arabia and Oman are the only host countries for our EEMEA utilities portfolio that we do not expect to suffer a slowing of GDP growth rate as a consequence of the slowdown in economic growth and mounting inflation.

Indeed, if macroeconomic environments deteriorate further, these rated companies could potentially face more painful developments, such as additional sharp increases in input cost inflation and weakening demand, as well as devaluation of the national currency, worsening payment collections and stronger regulatory pressure on tariffs driven by social and inflationary concerns.

In particular, the state-owned utilities most exposed to macroeconomic changes are those operating in Eastern Europe: Estonia, Kazakhstan, Lithuania, and Romania, which have negative outlooks for sovereign credit quality.

Indeed, state-owned utilities relying on support from the respective governments - for example, Kazakhstan Electricity Grid Operating Co. (JSC) (KEGOC) and KazTransGas - face the additional risk of shrinking sovereign support, as the ability to provide support may weaken commensurate with the national government's weakening credit quality.

Sovereign support

Meanwhile, the ratings on Saudi Electric Co. (SEC) reflect the company's continuing key role in the Saudi economy and the intention of the Kingdom of Saudi Arabia (AA-/Stable/A-1+) to remain supportive of SEC's credit quality.

The ratings also benefit from a strong forecast growth in electricity demand, as well as SEC's quasi-monopoly position in electricity generation and its monopoly position in electricity transmission and distribution services, with limited or no expected competition in the medium term.

We at Standard & Poor's analyse SEC using our criteria for government-related entities and view the company as a public-policy entity that benefits from implicit and explicit state support - albeit without an explicit financial guarantee.

Furthermore, SEC's tariff policy is effectively determined by the state, as the government is working toward a total solution for the power sector, with possible tariff rebalancing to accommodate the increased capital expenditure commitments dictated to SEC.

We also expect the government to continue to provide financial support to strengthen the company's balance sheet, which would better enable SEC to raise funding in the capital markets to support its capital expenditure programme in the future.

These credit strengths are offset by SEC's high commitments under its capital expenditure programme, which is expected to result in a deterioration of debt coverage ratios, as well as uncertainty about the company's sources of funding and regulatory risk affecting its three key business segments. In addition, SEC currently struggles to maintain a peak load capacity margin as demonstrated by brownouts.

Medium- to long-term plans, however, should ensure adequate capacity margins as long as its capital expenditure program progresses successfully.

Meanwhile, in the case of Oman Power and Water Procurement Co. SOAC (OPWP), the Sultanate of Oman's sole bulk buyer and seller of electricity and desalinated water, the government is required by law to maintain 100% ownership of the company, and to fund its operations.

However, while the company enjoys strong credit metrics, with all revenues regulated under a cost-plus tariff that allows full pass-through of procurement costs under normal circumstances, OPWP operates within a relatively untested regulatory framework and, as Oman's supply companies are privatised, counterparty risk increases.

M&A activity

Certainly, with many governments in the portfolio retaining control over large parts of the regional power sector, government-sponsored restructurings, privatisation and, in some cases, consolidation of national energy and utility companies fuel M&A activity in the region, which remains an important credit risk driver. Consequently, the ultimate impact on credit quality depends on the structure and financing of each M&A transaction.

Indeed, the restructuring of national power monopolies - usually accompanied by deregulation - is likely to weaken credit quality, due to the loss of the benefits of vertical integration and stronger competition, as well as increased electricity price volatility and pressure on liquidity if restructuring triggers "put" options on debt.

Security of supply

Certainly, most rated companies in the EEMEA region are increasing investments to improve energy supply security in their service area, rehabilitate or replace obsolete assets, and make growth investments.

In some instances, substantial increases in investment are linked to large investment projects, including the Baltic utilities Lietuvos Energija and Eesti Energija, which - together with their Latvian and Polish counterparts - plan to invest in the construction of a nuclear power plant at Ignalina in Lithuania with installed generation capacity up to 3.2 gigawatts (GW).

In addition, Kazakh oil pipeline operator KazTransOil plans to invest in a new oil export pipeline, Iskene-Kuryk, and the expansion of the Kazakhstan-Chinese pipeline for an estimated cost of up to US $2.4 billion, while Kazakh gas pipeline operator KazTransGas plans to invest in new gas pipelines connecting central Asian and western Kazakh gas producers with southern Kazakhstan and China, for an estimated cost of up to US $8.8 billion.

The company is also considering expansion of its Central Asian-Center pipeline.

We at Standard & Poor's view such investments as generally harmful to credit quality in the short term. They require large amounts of financing and often lead to a more aggressive financial profile if significant amounts of debt are employed.

For instance, the ‘BBB-' long-term corporate credit rating on United Arab Emirates-based district cooling company National Central Cooling Co. PJSC (Tabreed) has been placed on CreditWatch with negative implications, following Tabreed's announcement of its intention to implement a new business model under which the company may create a new asset holding company and divest existing and future assets into joint ventures.

In addition, the company has presented revised financial forecasts that anticipate, among other things, a significant increase in the future capital expenditure programme.

At present, uncertainty remains regarding the funding and level of any Tabreed investments in joint ventures as well as which assets would be transferred and at what value.

We consider that there could be a negative impact on short-term cash flow, partly reflecting increased capital expenditure, or higher levels of outstanding debt than previously considered within the rating category, which could adversely affect the company's ability to generate positive free cash flows by 2010.

In general, EEMEA utility involvement in expansion projects carries various additional risks, including associated construction risk, as well as the higher business risk of new projects. More positively, however, large energy infrastructure projects increase energy supply security and export potential.

And with states often deeming energy supply and exports to be strategically important, they are typically keen to provide strong political backing, which could translate into stronger political and financial support, thus mitigating project-level risks and boosting stand-alone credit quality.

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