Fitch Ratings has affirmed REN - Redes Energeticas Nacionais, SGPS, S.A.'s (REN) Long-Term Issuer Default Rating (IDR) and its senior unsecured ratings at 'BBB'.

The Outlook for the IDR is Stable. A full list of rating actions is below.

The affirmation of the IDR reflects REN's low domestic business risk profile as the sole gas and electricity transmission system operator (TSO) and the second-largest gas distributor in Portugal under a fairly supportive regulatory framework, which would sufficiently shield the company from high inflation and rising interest rates. The ratings also factor in higher leverage and a more generous dividend policy than the average of its European peers.

The Stable Outlook assumes regulatory stability and supportive market environment with higher Portuguese sovereign yields. The large share of fixed-rate debt should minimise the negative impact from rising interest rates. Fitch forecasts funds from operations (FFO) net leverage to be below the negative sensitivities for 2022-2025.

Key Rating Drivers

Solid Domestic Business Profile: REN's IDR reflects its solid business profile as the sole Portuguese TSO for electricity transmission and gas transport, regasification and storage and the second-largest gas distributor in the country. Almost all its domestic activities are fully regulated, under a long-standing and predictable regulatory framework, although with shorter regulatory periods (four years) and more volatile cash flows, due to less predictable tariff deviations than peers.

Regulatory Stability: Current regulatory periods run until 2025 for electricity and 2023 for gas. In 2022, the Portuguese regulator introduced a new totex framework for the electricity transmission business, which has been credit neutral for REN. Fitch expects the gas framework review to have a minimal impact on REN's business profile, similar to the most recent review.

Financial Profile Is Within Guidelines: We expect FFO net leverage to remain consistent with the guidelines for the 'BBB' over the forecasting horizon. In 2022, FFO will be negatively affected by higher taxes paid (due to the settlement of deferred taxes), while sizeable inflows (related to tariff deviations) will contribute to a decrease in net debt. Fitch sees net debt stabilising at about EUR2.7 billion over 2023-2024 as the company delivers the accumulated tariff surplus.

We forecast net debt to (regulatory asset base (RAB) + associates) decrease to 64% by 2025 from 68% in 2020 (negative guideline at 69%). REN maintains its commitment with the investment-grade credit metrics.

Resilient Against Inflation, Interest Rates: The regulatory rate of return (RoR) is indexed to the 10-year Portuguese sovereign bond yield and revised annually, allowing a quick pass-through of changes in the yield environment. The gas transmission framework includes yearly adjustments of allowed opex for inflation, while the electricity transmission framework includes annual adjustments of both allowed opex and D&A (the latter for assets built after January 2022).

The negative impact of rising interest rates will be limited over the coming years given that REN has a large share of fixed-rate debt (72% at end-2021). On the other hand, price increases for specific materials are outpacing inflation leading to capex overruns compared with the previously approved plan.

Elevated Energy Transition Capex: Fitch assumes REN's gross capex for 2022-2025 at about EUR300 million a year on average. However, a portion is supported through subsidies and cash receivables from solar promotors, with the latter cashed in before full capex deployment, allowing deleveraging to take place.

Electricity capex, about 80% of the total capex, largely focuses on enabling decarbonisation in Portugal and Chile, by allowing a higher integration of renewables and providing a more resilient service. For gas, the company aims to achieve a 5% blending of hydrogen into the grid through a low investment of about EUR40 million to 2026.

REN Trading PPAs Are Cash Flow Beneficial: Until November 2021, REN Trading ran two legacy power purchase agreements (PPAs) with Turbogas and Tejo Energia's power plants, with a full pass-through of their margins (no merchant exposure). The high electricity prices, coupled with favourable fuel contracts, implied high margins for the PPAs, and therefore a high stock of tariff deviation regulatory payables, working capital inflows and lower net debt in 2021 and (expected) 2022.

The Portuguese regulator makes ex-ante assumptions regarding demand and the electricity price. If the price rises above that assumed there is a tariff deviation in favour of the regulated company that manages the PPAs, which will be returned to the system within two years.

Lower Cash Flow Volatility from 2024: We forecast working capital unwinding in 2023-2024 as tariff deviation payables are returned to the system. A new accounting policy has removed the obligation to defer taxes for cash inflows from the PPAs but has required early settlement of existing deferred taxes in 2021, weakening FFO in that year.

Tariff deviations from REN Trading will naturally decrease due to the expiration of the remaining Turbogas PPA in 2024 (Tejo's PPA expired in November 2021), which is a positive development for the credit, in our view.

Revised Dividend Policy: REN revised its dividend policy for 2021-2024, reducing the dividend floor from EUR0.171 a share to EUR0.154 a share. This results in slightly lower dividends annually, with the exception of a bi-annual dividend distribution policy commencing in 2022. REN still has one of the most onerous dividend policies of its peers.

Derivation Summary

REN is the sole TSO for gas and electricity in Portugal. There is no other eurozone TSO that controls both gas and electricity transmission operations. REN entered the gas distribution business in Portugal in 2017 and has made international acquisitions of electricity and gas pipelines in Chile. We view the TSOs in Spain, Red Electrica Corporacion S.A. (A-/Stable) and Enagas S.A. (BBB/Stable), and in Italy, Snam S.p.A. (BBB+/Stable), as REN's closest peers.

Fitch considers REN's business risk profile as broadly aligned with Red Electrica, with lower revenue visibility (due to shorter regulatory periods and higher cash flow volatility) balanced by framework stability across regulatory periods, supported by a truly independent regulator and a better protection from inflation and a higher proportion of regulated earnings. Enagas has a higher business risk profile than REN, mainly due to the sizeable cash flow contribution from higher-risk and unregulated businesses.

REN's ratings are one notch lower than Snam's, mainly due to a lower debt capacity and higher leverage, and two notches lower than Red Electrica's, mainly due to leverage. Enagas has materially lower leverage than REN, but the same rating, in light of its lower debt capacity.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer

-Downward review of the gas (transmission and distribution) base RoR at the time of the regulatory reset (January 2024) by 20bp, eliminating the spread to the electricity RoR but maintaining the spread between gas transmission and distribution (at 20bp);

10-year Portuguese government bond steadily increasing to 3.36% in 2025 from 2.68% in 2022 (it is currently at about 3.4%);

Borrowing costs fixed at 4.0% for new debt;

RAB slightly increasing to EUR3.7 billion by end-2025 from about EUR3.6 billion at end-2021;

Tariff deviation stock increasing to EUR618 million in 2022 and decreasing sharply thereafter to EUR8 million in 2025, which implies a sizeable cash absorption from working capital from 2023;

Average capex (net of subsidies and solar promotors receivables) of about EUR260 million a year in 2022-2025;

Dividends over the period slightly above the EUR0.154 dividends per share floor with a payout ratio of about 100%.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:

Expected FFO net leverage below 6.3x and net debt/(RAB + associates) below 60% on a sustained basis.

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade:

FFO net leverage above 7.0x; expected net debt/(RAB + associates) above 69%, and FFO interest coverage below 3.0x, on a sustained basis.

Negative changes to the regulatory framework beyond our current expectations, or further adverse fiscal measures.

Stated financial policy that is no longer commensurate with our sensitivities for the 'BBB' rating.

A one-notch downgrade of REN's IDR to 'BBB-' would not lead to similar action on the senior unsecured rating as it would benefit from a one-notch uplift from the IDR due to expected above-average recoveries if the Portuguese sovereign rating remains at least 'BBB'.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Liquidity: At end-June 2022, REN had about EUR545.6 million of readily available cash and around EUR875 million of committed undrawn facilities available. This comprises EUR400 million of commercial paper (under a subscription guarantee) and EUR475 million of undrawn bank loans maturing in 2024-2027. This compares with EUR877 million of maturities until end-December 2023 and broadly neutral cumulative free cash flow. This liquidity position is sufficient to cover operating and funding needs for the next 24 months, which is in line with the company's policy.

Centralised Debt Structure: The structure is a standard corporate financing model and has no impact on the ratings as the bulk of debt is issued and managed at the holdco and finco, the latter supported by keep-well agreements. All debt is senior unsecured.

Issuer Profile

REN is the sole Portuguese TSO for electricity transmission and gas transport, regasification and storage. Since 2017, it has also owned the second-largest gas distribution concession in Portugal. REN's average RAB in Portugal stood at EUR3.6 billion in 2021. It also owns a 42.5% of the Chilean pipeline Electrogas, the owner of a gas pipeline whose revenue is linked to long-term pay-or-take contracts, and Transemel, an electricity transmission company in Chile whose revenue comes from a stable regulatory framework.

Summary of Financial Adjustments

We reclassify the long-term part of the tariff deviation as working capital.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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