Fitch rates Ceylon Electricity Board’s proposed debentures ‘AA+(lka)’

lbo_fitchratings

Fitch Ratings has assigned Ceylon Electricity Board’s (CEB: AA+(lka)/Negative) proposed senior unsecured debenture issue of up to LKR20 billion a National Long-Term Rating of ‘AA+(lka)’.

The debentures constitute direct, unsubordinated and senior unsecured obligations of CEB and are rated at the same level as the entity’s National LongTerm Rating. CEB’s ratings are equalised with that of its parent, the Sri Lankan sovereign (B/Negative), in line with Fitch’s Parent and Subsidiary Rating Linkage criteria.

The equalisation takes into consideration CEB’s strategic importance to Sri Lanka in ensuring power security and supply of affordable electricity to the public. The proposed debentures will be listed on the Colombo Stock Exchange and are expected to have a fixed coupon rate with a maturity of five years, with proceeds to be used for general working capital purposes.

KEY RATING DRIVERS

Strong Linkages with State: Fitch assesses the linkages between CEB and the state to be strong, reflecting explicit guarantees and financial support through equity infusions and debt funding. The government also implicitly guarantees CEB’s project loans, which account for around 80% of its outstanding debt. These loans are extended by bilateral and multilateral agencies and routed through the government for development of power infrastructure. CEB’s strategic importance to the state stems from its position as the country’s sole grid operator and distributor and the generator of 80% of electricity in Sri Lanka. Fitch believes the Sri Lankan government uses CEB as a vehicle to provide an essential public service. CEB provides electricity at subsidised tariffs without adequate and timely financial compensation from the government. We do not expect CEB’s linkages with its parent to weaken in the medium term as the provision of electricity at subsidised rates can be carried out only by a state entity such as CEB, because private companies would not be willing to bear losses.

Weak Standalone Profile: Fitch assesses CEB’s standalone credit profile to be much weaker than its support-driven rating and believes providing a notchspecific standalone credit view of CEB is difficult due to poor margin visibility and the need for continued state support to sustain operations. CEB continues to make operating losses because tariffs are lower than its average generation, distribution and transmission costs – which compel CEB to borrow even to sustain its day-today operations. The balance sheet is further weakened by significant investments on new generation capacity and network upgrades funded primarily through borrowings. Weak Financial Profile: CEB posted an EBITDAR of LKR17 billion in 2018, but its free cash flow (FCF) generation was a negative LKR66 billion amid high interest costs, working capital outflows and capex. We expect CEB’s EBITDAR to remain weak in the medium term, especially in the absence of an increase in tariffs and rising generation costs. Similarly we expect FCF generation to remain negative over the medium term due to its aggressive expansion plans, which will lead to higher debt levels and further weakening in its balance sheet.

Unfavourable Tariff Structure: We do not believe the government will adopt a tariff structure for electricity that reflects the cost of production and distribution with the upcoming elections in 2020. CEB’s current average tariff, which has not been revised since 2013, is around 10%-15% below the average cost of supplying a unit of electricity. The government has succeeded in introducing cost-reflective pricing formulas for other essential goods, such as fuel and liquefied petroleum gas, but there is no indication whether this will be adopted for electricity. By law, the government has to bear the costs of any subsidies provided by CEB to its customers.

However CEB has not been fully compensated for subsidy-related losses in the past. Significant Investments in Generation: The regulator expects electricity demand in Sri Lanka to increase by about 6% per year in the next five years, which will require significant capacity expansions if the industry is to make up for the existing supply shortage. Hydro power, which accounts for around 41% of country’s power generation, has been highly volatile in the past few years due to unfavourable weather patterns. This pushed CEB to look for alternative sources, such as natural gas and other renewable energy sources. CEB, which is tasked with improving the country’s power infrastructure, will have to bear bulk of these investments, which management estimates at around USD1.7 billion over 2019- 2022.

DERIVATION SUMMARY

Fitch rates CEB at the same level as the sovereign due to the strong linkages with its parent. The equalisation reflects strong legal, operational and strategic linkages, as evidenced by the state’s record of financial support through explicit guarantees, equity infusions and subsidised debt funding. CEB provides electricity at subsidised rates, fulfilling an essential service for the sovereign. CEB has almost full network connectivity and accounted for more than 80% of Sri Lanka’s generation capacity in 2018. Our assessment of CEB’s linkages with the sovereign can be compared with that for other Sri Lankan government-related entities, such as Sri Lanka Telecom PLC (SLT, AA+(lka)/Negative), which we also regard as having strong operational and strategic linkages with the sovereign.

However, CEB’s credit profile is weaker than that of the sovereign and its rating is equalised due to strong state linkages, while SLT has a stronger credit profile than the sovereign and its rating is constrained by strong linkages with the state. KEY ASSUMPTIONS Fitch’s Key Assumptions Within Our Rating Case for the Issuer – Sri Lanka’s annual electricity demand to increase by an average of 6% per year over 2019-2021 – No material increase in electricity tariffs in the next 12-15 months – Generation mix to broadly remain at 25% coal, 30% fuel, 35% hydropower and 10% others. – Capex of LKR90 billion-100 billion per annum in the next two years; mainly spent on new generation capacity

RATING SENSITIVITIES

Developments that May, Individually or Collectively, Lead to a Revision of the Outlook to Stable – A revision of our Outlook on Sri Lanka’s Long-Term Foreign-Currency IDR to Stable from Negative. Developments that May, Individually or Collectively, Lead to a Negative Rating Action are: – A significant weakening of the strong linkages between the sovereign and CEB. – A downgrade of the Sri Lankan sovereign’s Long-Term IDR would result in corresponding action on CEB’s National Long-Term Rating. For the sovereign rating of Sri Lanka, the following sensitivities were outlined by Fitch in the agency’s Ratings Action Commentary of 18 December 2019: The main factors that individually, or collectively, could trigger a downgrade are: – Failure to place the gross general government debt/GDP ratio on a downward path due to wider budget deficits or the crystallisation on the sovereign balance sheet of contingent liabilities that are linked to state-owned entities or government-guaranteed debt. – Increase in external sovereign funding stresses that threaten the government’s ability to meet upcoming debt maturities, particularly in the event of a loss of confidence by international investors. – A further deterioration in policy coherence and credibility, leading to lower GDP growth and/or macroeconomic instability.

The main factors that, individually or collectively, could lead to a revision of the Outlook to Stable: – Stronger public finances, underpinned by a credible medium-term fiscal strategy that places gross general government debt/GDP on a downward path, accompanied by higher government revenue. – Improvement in external finances, supported by lower net external debt or a reduction in refinancing risk; for example, from a lengthening of debt maturities or increased foreign-exchange reserves. – Improved macroeconomic policy coherence and credibility, evidenced by more predictable policy-making and a track record of meeting previously announced economic and financial targets.

LIQUIDITY AND DEBT STRUCTURE

Government Linkages Support Liquidity: As at end-September 2019, CEB had LKR2.7 billion of unrestricted cash against LKR14.5 billion of debt falling due in the next 12 months leaving CEB in a weak liquidity position. Further we expect CEB to incur around LKR100 billion in capex, which would not be met through internally generated funds as it has operating losses. As such, we expect the government to step in and provide funding support as seen in the past. The successful issuance of the proposed debenture should also help mitigate the near-term liquidity pressure