Standard & Poor’s has warned that the credit ratings of European electric utilities are under threat because of the EU directive on market liberalization. Is this the downside of competition? Siân Green reports.
A recent report by Standard & Poor’s (S&P), the credit ratings agency, has warned that the future credit ratings of European electricity utilities could be harmed as liberalization and competition take hold. Competition brought about by the EU directive on electricity market opening means that ratings in the sector over the next decade could be downgraded, said the agency.
European electric companies previously operated as regional or national monopolies, and traditionally have had some of the highest credit ratings of European industrial companies. They usually command a rating of between BBB and AA+. Increased competitive pressures may see them reduced to between A and BBB.
Although only enforced one year ago, the EU directive has already had a significant impact across Europe in terms of industry structure, prices and customer expectations. While most countries have implemented only the minimum level of market opening required by the directive, several have gone much further, opening their markets completely.
Ironically, those utilities in markets where competition is advanced, are more likely to see a downgraded credit rating due to competitive pressures.
Driven by the EU directive and the realisation by utilities of the need to gain a strong market share early on, liberalization in Europe has generally taken hold faster than expected. The UK, Germany, Finland and Sweden have all opened their markets 100 per cent, and Spain’s market is 55 per cent open. France and Austria are the least advanced markets in the EU, but S&P says that with momentum for liberalization building, “market dynamics will outpace the legislative machine” by 2003, when markets are required to be 33 per cent open.
According to S&P, utilities in liberalized markets are now seeing tougher regulation, falling prices, increased competition and merger activity, and as these trends continue, a downward credit trend among European utilities is likely as margins are squeezed.
One of the most strongly competitive electricity markets in Europe is in the Nordic region – Finland and Sweden began market opening in 1995 and 1996, respectively, while Norway (a non-EU country) opened its market fully in 1991. These countries, together with western Denmark, form a single electricity market where cross-border tariffs have been abolished and the Nord Pool and El-Ex exchanges promote liquidity. Simple market access rules, transparent pricing, oversupply and an abundance of hydropower capacity has made the market fiercely competitive.
In the Nordic region, S&P expects competition to heighten, bringing further price pressures and decreasing margins on the utilities, which will harm the region’s credit profile. Competitive pressure already resulted in a one-notch downgrade of Vattenfall and Sydkraft in May 1999.
Consolidation in the market is also expected in the Nordic region as utilities seek the benefits of economies of scale. Major consolidation is currently being witnessed in Germany and the Netherlands, where market opening began in 1998.
The impact of the EU directive on the Dutch electricity market has been extensive, with fundamental structural changes occurring. Market risks for the generators will mainly be brought by declining prices and higher volatility, and credit quality may deteriorate depending on ownership changes, exposure to stranded costs – estimated to be more than $930m – and generation and operational cost profiles.
The entire German market is also undergoing consolidation, and like the Nordic region and the Netherlands, has also seen cross-border investment activity. Mergers and acquisitions are occurring from the eight main energy companies right down to the municipal distribution and supply companies. And while mergers, such as between RWE and VEW, will help these utilities become more efficient and achieve cost savings, S&P states that further consolidation will harm credit ratings.
Mergers such as RWE/VEW and Veba/Viag have been financed through equity rather than debt. However, S&P believes that debt financing will become the preferred option for merger and acquisition activity among utilities. As a result, “ratings are likely to trend down over the next decade” as debt financing may impair capital structure and cash flow.
Credit ratings are also at risk in the UK, but more due to regulatory activity than competitive forces. While most European countries have been slow to introduce independent regulators alongside deregulation, the UK regulator has been vigorous in trying to ensure that utilities operate efficiently and that customers see the benefits of competition.
The UK is currently passing legislation to replace its power pool system with new trading arrangements (NETA), which the government hopes will see a ten per cent reduction in wholesale prices through an increase in liquidity and transparency. This will affect generators’ margins and will therefore have a negative impact on their credit ratings, except for those with a balanced, flexible, multifuel portfolio, or those with a vertical structure giving them access to consumers.
The distribution sector in the UK will see a similar fate. The regulator’s recent distribution price review, designed to increase efficiency, was seen as particularly harsh by both analysts and utilities, and resulted in a deterioration in credit quality. The review prompted TXU’s Eastern Electricity and EDF-owned London Electricity to form a joint venture to operate their distribution units, and further activity of this kind is expected.