Moody's: Australian regulated networks sector stable but countermeasures required to offset declining returns

Moody's Investors Service says that its stable outlook on the Australian regulated electricity and gas networks reflects the transparent and predictable nature of the regulatory framework, but that networks may need to implement countermeasures to manage declining regulatory returns.

"The regulator's consistent approach to setting rates of return provides networks with a window to implement countermeasures to manage revenue reductions, which in recent decisions have reflected low interest rates rather than changes in regulatory intent," says Mary Anne Low, a Moody's Analyst.

"The decline in regulatory rates of return will reduce networks' financial headroom to manage unexpected challenges, a credit negative, but we expect networks will take measures to preserve their credit profiles where required," adds Low.

Such measures include entering into new interest rate swaps at lower prevailing interest rates, reducing costs and using operating cash flow to fund capex as opposed to equity distributions.

Moody's analysis was contained in its just-released 2016 outlook on Australian Regulated Electricity and Gas Networks, entitled "Transparency in Regulatory Framework Supports Stable Outlook, but Countermeasures Required to Offset Declining Returns."

Moody's outlook reflects its expectations for the fundamental business conditions in the industry and that networks will implement countermeasures to offset declining regulatory returns from low risk free rates over the next 12-18 months. Moody's has maintained a stable outlook for the industry since early 2014.

Moody's points out that single-asset networks and highly leveraged capital structures are subject to higher downside risk from reduced regulatory returns. The credit profile of such networks could be vulnerable if risk free rates -- the fundamental building block of their regulatory returns -- do not materially increase.

Such rated issuers include ETSA Utilities Finance Pty Ltd ((P)A3, the financing vehicle for SA Power Networks (unrated)), Powercor Australia LLC (Baa1) and United Energy Distribution Pty Limited (Baa2), which are subject to regulatory reset over the next 12 months. The final impact on these networks' credit profiles will depend on prevailing risk free rates at their next regulatory reset and the countermeasures they may apply.

Moody's also sees it as unlikely that competition from combined solar generation and battery storage will affect the essential nature of regulated networks. Power production by rooftop solar panels in Australia is still very low at less than 5% of total generation, reflecting the lack of reliable and cost-competitive storage technologies and reduced subsidies for solar panel installations.

"Because users of solar panels need to remain connected to the grid, electricity networks will remain essential," says Low. "Longer-term implications for the networks will depend on the extent to which the cost and reliability of battery storage become competitive with grid-supplied power."

Moody's could change its outlook to negative if the regulator departs materially from its published guidelines in setting regulatory returns.

Moody's does not expect any conditions that would lead to a change in outlook to positive over the next 12 to 18 months, given the downward pressure on regulatory rates of return and the short history of the regulator's application of its new rate of return guidelines.