Southern Gas Networks plc - SGN · SGN Commercial Services, a company outside the MidCo group...

INFRASTRUCTURE AND PROJECT FINANCE

CREDIT OPINION27 February 2020

Update

RATINGS

Southern Gas Networks plcDomicile United Kingdom

Long Term Rating Baa1

Type LT Issuer Rating - DomCurr

Outlook Negative

Please see the ratings section at the end of this reportfor more information. The ratings and outlook shownreflect information as of the publication date.

Contacts

Philip Cope [email protected]

Matthew Brown +44.20.7772.1043Associate [email protected]

Neil Griffiths-Lambeth

+44.20.7772.5543

Associate Managing [email protected]

Southern Gas Networks plcUpdate to credit analysis following business plan submission

SummaryThe credit quality of Southern Gas Networks plc (Southern GN, Baa1 negative) is supportedby: (1) the company's natural monopoly position as the licensed provider of gas distributionservices in the South of England and the low business risk of those activities; (2) the well-established and transparent regulatory regime in Great Britain, which underpins stable andpredictable cash flow; and (3) strong performance in relation to regulatory outputs in thefirst six years of RIIO-GD1 through March 2019. However, the company’s credit quality isconstrained by: (1) its policy of maintaining relatively high financial leverage, as measuredby its net debt/regulated asset value (RAV) of 70%-75%; and (2) the scope for additionalleverage at Southern GN's parent company, SGN MidCo Limited (SGN MidCo), which underits financing structure can increase consolidated leverage to 85% of RAV, excluding ouradjustments.

Southern GN's adjusted interest coverage ratio (AICR) of 1.7x in 2018-19 is supported bytotex outperformance and non-distribution activities, although partially offset by increasedproperty taxes (known as business rates), which the company will only be able to recoverwith a two-year lag. We estimate AICR to be 1.6x in 2019-20 and 2020-21.

Exhibit 1

Totex outperformance and non-distribution activities support interest coverMoody's AICR for financial year ending March 2019

1.3x

1.9x1.7x

0.0x

0.2x

0.4x

0.6x

0.8x

1.0x

1.2x

1.4x

1.6x

1.8x

2.0x

BaseReturn

TotexPerformance

& Mix

Sharing ofPerformance

& Legacy

IncentivePayments

Tax vs.Allowances

Non-DistributionBusiness

AICR beforeTiming

Differences

TimingDifferences

AICR

Minimum Baa1 guidance

Source: Moody's Investors Service

The negative outlook reflects the risk that the AICR will fall below our minimum 1.4xguidance for the current rating level in the RIIO-GD2 period that starts in April 2021, giventhe reduction in returns and opportunities for outperformance signalled by the regulator.

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MOODY'S INVESTORS SERVICE INFRASTRUCTURE AND PROJECT FINANCE

Credit strengths

» Well-established and transparent regulatory framework, underpinning stable and predictable cash flows with visibility till March2021

» Track record of strong operational performance, both against regulatory cost allowances and on delivery of required outputs, whichwe expect to continue for the remainder of RIIO-GD1

Credit challenges

» High leverage at the consolidated SGN MidCo group level

» Downward pressure on interest coverage from anticipated reductions in allowed returns from April 2021, only partially offset by themove to CPIH indexation, a structurally lower measure of inflation indexation

Rating outlookThe negative outlook reflects the risk that, absent offsetting measures or operational outperformance, the AICR will fall below ourguidance for the current rating of at least 1.4x at Southern GN and 1.2x at the consolidated SGN MidCo group, in the RIIO-GD2regulatory period that starts in April 2021.

Factors that could lead to an upgrade

» Given the negative outlook, we currently see little potential for upward pressure

» The outlook could be stabilised if the regulatory determination for RIIO-GD2 makes it likely that expected returns, includingreasonably probable operational outperformance, will support interest coverage metrics consistent with the assigned rating

» The outlook could also be stabilised if the SGN group took measures to strengthen its balance sheet and/or materially reducefinancing costs

Factors that could lead to a downgrade

» Regulatory decisions for RIIO-GD2, in particular on allowed returns and regulatory cost allowances, that are unlikely to support anAICR of at least 1.4x at Southern GN and 1.2x at SGN MidCo

» Net debt/RAV above 75% for Southern GN or over 85% for the consolidated SGN MidCo group

Key indicators

Exhibit 2

Southern Gas Networks plcFor RIIO-GD1 period

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 2020-proj. 2021-proj.

Adjusted Interest Coverage Ratio 1.9x 2.8x 1.4x 1.9x 1.3x 1.7x 1.6x 1.6x

Net Debt / RAV 71.7% 80.4% 72.1% 71.9% 73.1% 71.9% 72.2% 72.2%

FFO / Net Debt 14.7% 17.3% 11.3% 12.1% 10.0% 11.3% 11.0% 10.9%

RCF / Net Debt 14.7% 17.3% 11.3% 6.9% 5.8% 8.9% 7.9% 7.9%

All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. Projections (proj.) are our opinion and do notrepresent the views of the issuer.Source: Moody's Financial Metrics™

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 27 February 2020 Southern Gas Networks plc: Update to credit analysis following business plan submission

https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1106999


Following the implementation of the MidCo structure, SGN's established policy is to pool cash between the regulated entities withinthe MidCo group. Prior to the restructuring, excess funds from the operating companies were instead lent to the parent. SouthernGN's net debt/RAV temporarily increased in 2015 as the company issued bonds to partially pre-fund maturities in 2016, while theintercompany loan receivables were not netted against debt, resulting in a higher leverage calculation than it would have been if excesscash was held at the operating companies.

AICR at the consolidated MidCo group was 1.5x in 2017-18 and 1.5x in 2018-19.

ProfileSouthern GN is the largest of the eight gas distribution networks (GDNs) in England, Wales and Scotland by Regulated Asset Value. Itprovides gas distribution services to around 4.0 million customers through about 49,000 kilometres of gas pipelines in the South ofEngland, including the cities of Milton Keynes and Dover, and London boroughs south of the River Thames.

Southern GN is a wholly owned subsidiary of Scotia Gas Networks Limited (SGN HoldCo) via the intermediate holding companies SGNMidCo Limited (SGN MidCo) and SGN PledgeCo Limited. SGN HoldCo is, in turn, owned by a consortium including SSE plc (Baa1/P-2stable), OMERS, Ontario Teachers’ Pension Plan Board (Aa1 stable) and the Abu Dhabi Investment Authority.

SGN also owns another gas distribution network in Great Britain, Scotland Gas Networks plc (Scotland GN, Baa1 negative). The twonetworks are operationally managed as one entity, although for regulatory reasons they remain legally separate and independent ofeach other and their respective performances are judged on a standalone basis. SGN (through a separate legal entity within the SGNMidCo group, SGN Natural Gas Limited) is part of an alliance with Mutual Energy for construction of the Gas to the West project inNorthern Ireland. The main construction phase completed and commissioned in December 2019.

In 2014, an alliance of SGN and Mutual Energy were awarded the contract to build and operate new gas pipelines in the west ofNorthern Ireland, known as Gas to the West. SGN Commercial Services, a company outside the MidCo group undertook constructionof the transmission pipeline, which was completed and commissioned in December 2019. SGN Natural Gas Limited (a separate legalentity within the SGN MidCo group) constructed, owns and operates the distribution network in eight towns across Northern Ireland.

Exhibit 3

Regulated Asset Value by gas distribution network operator groupClosing RAV at 31 March 2019, nominal

49%

11%

29%

11%

East of England, £3.3bn

London, £2.3bn

North West, £2.3bn

West Midlands, £1.7bn

Northern, £2.2bn

Scotland, £1.8bn

Southern, £3.9bn

Wales & West, £2.2bn

Cadent, £9.7bnSGN, £5.7bn

Note: RAV shown following Annual Iteration Process (AIP) in November 2019.Source: Ofgem, Moody's Investors Service

As of 31 March 2019, Southern GN had a RAV of £3.9 billion. In the regulatory year to that date — the sixth year of the RIIO-GD1regulatory period — the company earned revenue of £797 million and operating profit of £366 million.


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Detailed credit considerationsWell-established and transparent regulatory framework underpins stable and predictable cash flow; good visibility untilMarch 2021The GDNs in Great Britain benefit from a very transparent, stable and predictable regulatory regime based on clearly defined riskand reward principles. It is overseen by an experienced regulator, the Office of Gas and Electricity Markets (Ofgem), with a long trackrecord of consistent decision making. Ofgem has consulted widely with a variety of stakeholders whenever changes to the regulatoryframework have been made in the past. Southern GN has significant visibility in relation to future cash flow under the current pricecontrol for gas distribution (RIIO-GD1), which began on 1 April 2013 and runs until 31 March 2021.

Exhibit 4

Southern GN service areaExhibit 5

Price control overview

Source: Energy Networks Association

GB Gas Distribution

Regulator/ Price Control Ofgem / RIIO-GD1

Regulated Business Southern Gas Networks

Term of price control 2013-21

Allowed return on RAV (vanilla real) 3.37% (2019-20),

3.05% (2020-21)

Company's forecast eight-year Return on

Regulatory Equity

10.7% vs 6.7% assumed

cost of equity

Regulated Asset Value (March 2019) £3.9 billion

Source: Ofgem

The RIIO regulatory framework included provisions for a mid-period review in 2017 that was intended to deal with clear changes ingovernment policy or consumers' and network users' needs. On the basis of the stated, limited purpose of the mid-period review,Ofgem determined that no review was needed for gas distribution.

However, following the decision, several GDNs made what were described as “voluntary contributions to reduce customer bills. Thecompanies explained their decisions in terms of allowances that were no longer required or reopeners that they would not claimdespite being entitled to do so. SGN, across both of its networks, returned a package of £145 million to customers, including returning£50 million of repex allowances, not claiming additional allowance through a reopener, and additional unfunded resilience and fuelpoor work during RIIO-GD1.

We believe the payments evidence the difficult environment in which the sector now operates, with affordability of utility bills highon the political agenda. The impact of the lost revenue will be relatively modest for the companies that chose to make contributions.However, if political pressure leads to further interventions, it could, over time, weaken our assessment of the transparency, stabilityand predictability of the regime.

Latest regulatory proposals suggest significantly lower returns in RIIO-GD2Ofgem's sector specific methodology decision for the next regulatory period (RIIO-GD2), published in May 2019, outlines as a “workingassumption”, that companies should be allowed to earn a cash return of 2.88% on average over the period, in addition to inflationof their RAV based on the Consumer Prices Index including owner occupiers' housing costs (CPIH). This compares to a cash returnof 3.05% before RPI inflation in 2020-21. Since the RPI measure of inflation is structurally higher than that of CPIH, by around 1percentage point, this represents a reduction in total (nominal) returns of around 20%, to around 4.9% from around 6.1%.



We note that the proposed reduction in returns is slightly smaller, by around 24 basis points (before inflation), than Ofgem's priorworking assumption from December 2018 because Ofgem plans to use a longer-term trailing average to set the cost of debt allowanceand a higher estimate of the sector's equity beta.

Cost of debt indexation under RIIO-1

As part of RIIO, Ofgem introduced an “indexed” cost of debt allowance which changes annually through the regulatory period. The indexis based on specific iBoxx indices and the breakeven yield on UK government bonds. For transmission and gas distribution companies theallowance is currently based on a 10-year trailing average of the index.

Cost of debt indexation under RIIO-2

The intention for the forthcoming gas distribution and transmission controls, is to use a trailing averaged calculated on an “extending” basiswith a fixed starting point. Ofgem envisage that the length of the index would rise from eleven to fifteen years over the five years of thecontrol. Breakeven inflation would also be replaced by an assumed 2% CPI level.

Extending the period of the trailing average will mean that the yields from the early part of this decade, materially above current levels, will bekept in the index for longer and result in a higher cost of debt allowance than under a 10-year trailing average (absent a material rise in rates inthe next few years).

Due to the low real interest rate environment since the global financial crisis, the calculated value of the allowed return on debt hasfallen to 1.58% in 2019-20, and will fall to 1.09% in 2020-21, from 2.92% (pretax, real) at the start of the RIIO-GD1 (and RIIO-T1)controls. Our central case is that market interest rates will rise over time, and under this scenario, the allowed cost of debt wouldstabilise below 1%, on a comparable basis, in RIIO-GD2 (below 2% in CPIH rather than RPI terms).

Exhibit 6

Ofgem's cost of debt allowance will continue to fall over the remainder of RIIO-GD1Evolution of cash cost of debt allowance for GDNs

3.55

2.922.72 2.55 2.38 2.22

1.911.58

1.09

1.95 1.86 1.84 1.86 1.92

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr 13 Apr 14 Apr 15 Apr 16 Apr 17 Apr 18 Apr 19 Apr 20 Apr 21 Apr 22 Apr 23 Apr 24 Apr 25 Apr 26

%

Spot yield (real, breakeven RPI-stripped) Spot yield (real, Ofgem assumed 2% CPI-stripped)

Cost of debt allowance (fixed, RPI-stripped) Cost of debt allowance (10 year average, breakeven RPI-stripped)

Cost of debt allowance (11-15 year average, assumed CPI-stripped)

GDPCR1 RIIO-GD1 RIIO-GD2

Notes: Based on Ofgem's determined allowances till 31 March 2021; the Moody's central case forecast from 1 April 2021 onwards, using Ofgem's current “working assumption” for theindex specification. Allowances would be lower under market-implied forecasts.Source: Moody's Investors Service

Declining allowed returns will hurt returns for the whole British regulated energy sector. However, with a weighted average maturity ofaround 8 years on its fixed and index-linked debt, in line with the regulator's current index for RIIO-GD1, Southern GN's cost of debtshould decline broadly in line with the regulatory allowance.



Southern GN has 17% of its debt indexed to RPI, which reduces its cash interest costs and results in stronger cash interest coveragemetrics than would have been if the company was funded entirely with nominal debt.

RIIO-GD2 determinations expected late 2020Southern GN, along with the rest of the sector, published its final RIIO-GD2 business plan in December 2019. Southern GN hasrequested on average £416 million of annual totex allowances (in 2018-19 prices), of which £34 million would be spent on 'deliveringenhanced customer outputs'. This includes accelerated work on the repex programme, resulting in 81% of the network usingpolyethylene pipe by 2026.

Exhibit 7

Requested RIIO-GD2 totex is similar to RIIO-GD1 expenditure£ million 2018-19 prices

-

50

100

150

200

250

300

350

400

450

500

2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26

GD1 Outturn GD1 Forecast GD2 Request

Capex Repex Controllable Opex Allowed totex (post-AIP 2019)

Source: Company business plan

Southern GN propose to retain the current 45 year front loaded depreciation profile of the RAV and to capitalise totex at a similar rateto their capex/opex split. Under Ofgem's 2.88% working assumption for the cost of capital, Scotland GN's impact on average customerbills would decrease by 13% before inflation over RIIO-GD2. SGN have requested a higher allowed return of 4.01% in CPIH terms,including retaining the higher RIIO-GD1 65% notional gearing level and using a 15 - 20 year trailing average index for the cost of debtallowance, which would be higher than Ofgem's proposed 11 - 15 year index.

Ofgem will now assess the company's business plan before making its decision later this year. Ofgem's latest update1 stated that draftdeterminations would be published in July 2020 and final determinations in November 2020.

Strong regulatory performance during RIIO-GD1Southern GN has demonstrated a track record of strong operational performance against regulatory cost allowances and in delivery ofrequired outputs, which we expect to continue for the remainder of RIIO-GD1.



The RIIO totex framework

For RIIO-GD1, like other RIIO price controls in gas and electricity, allowed expenditure is determined and performance is assessed on a totexbasis, which combines all controllable capital and operational costs. The share of any outperformance or underperformance, which is retainedby the company, is determined using the Information Quality Incentive mechanism. This is intended to reward companies that apply levels ofallowed expenditure that align with the regulator's view of efficient costs.

For Southern GN, the incentive rate (that is, the percentage of any efficient under- or overspending on totex that the company retains or isexposed to) is 64% for RIIO-GD1. Southern GN's incentive rate is one of the highest among the eight GDNs, reflecting a business plan thatincluded forecast costs close to that of Ofgem's own assessment.

For gas distribution companies, the main scope for outperformance is in cost efficiency. Southern GN achieved totex savings of £49million (10.6%) during the sixth year of RIIO-GD1, compared with the industry average of 10.4%. Of the £49 million savings, around£18 million will ultimately be shared with customers. Over the first six years of RIIO-GD1, Southern GN's expenditure has been 16.8%lower than the adjusted allowance, with most savings achieved on opex.

Exhibit 8

Southern GN has spent less than allowances in all categories of expenditureSix-year cumulative over-/underspend against allowances by GDN

-40%

-30%

-20%

-10%

0%

10%

East of England London North West West Midlands Northern Scotland Southern Wales & West

Cadent Gas NGN SGN WWU

Operating expenditure Replacement expenditure Capital expenditure Totex

Sources: Ofgem, company reports

While part of the underspend in these years may be a result of a different phasing of spending than assumed by Ofgem, we expectSouthern GN to outperform materially on totex over the period as a whole, given the structural nature of the changes implementedsince the beginning of RIIO and the SGN group's frontier performance on cost efficiency in the previous regulatory period (GDPCR1).Southern GN expects to underspend the eight-year totex allowance by 13% in total.

Ofgem also assesses companies against a number of output measures that are intended to reflect the minimum that customers requireof a GDN, including in relation to customer service, shrinkage/leakage volume, fuel poverty and other social outputs, asset health andreliability (including interruptions to supply). Southern GN has exceeded the required standards for all the outputs during the firstsix years of RIIO-GD1. Currently, Southern GN forecasts that its eight-year target for fuel poor connections is at risk but is investingadditional resources to address this. In RIIO-GD1, the financial incentives attached to these outputs are small. In 2018-19, Scotland GNand Southern GN together earned £24.4 million of incentives revenue, to be collected in 2020-21.

Long term decline in gas demandAlthough SGN continues to make significant investments in the network in order to maintain reliability and safety, underlying averageannual gas demand is falling sharply. Gas consumption in Great Britain fell 14% between 2010 and 2018, from 934 terawatt hours(TWh) to 804 TWh equivalent; however, peak demand2 which drives the GDNs investment requirements has fallen more modestly, byonly 6% over the corresponding period.



National Grid Electricity System Operator Ltd's (Baa1 stable) latest Future Energy Scenarios forecasts that average demand mayfall by as much as a further 22% by 2021 or 39% by 2030. Gas demand remains highest in the 'Steady Progression' scenario, wheretotal energy demand remains high and gas is used for heavy goods vehicle traffic and to produce hydrogen, alongside today's uses.Gas demand is lowest in the 'Community Renewables' scenario, where large scale renewables penetration displaces gas generation,hydrogen is produced via electrolysis rather than gas (although may still require the existing gas network for transportation) and energyefficiency reduces overall demand.

However, unlike in previous years, peak demand, for which the network is sized to meet, increases under the 'Steady Progression' and'Consumer Evolution' scenarios. This primarily relates to the adoption of hybrid heating systems, which reduce annual but not peak gasdemand.

Exhibit 9

Gas demand is likely to decline further in all scenarios...Future Energy Scenarios 2019

Exhibit 10

...however peak demand declines more slowly, and may increase insome scenariosFuture Energy Scenarios 2019

0

100

200

300

400

500

600

700

800

900

1,000

2010 2015 2020 2025 2030 2035 2040 2045 2050

TW

h/y

ea

r

Outturn Community Renewables

Two Degrees Steady Progression

Consumer Evolution

Note: Annual gas demand per calendar year, excluding shrinkage and exports.Source: National Grid Electricity System Operator

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2010 2015 2020 2025 2030 2035 2040 2045 2050

GW

h/p

ea

k d

ay

Outturn Community Renewables

Two Degrees Steady Progression

Consumer Evolution

Note: Gas 1-in-20 peak demandSource: National Grid Electricity System Operator

In June 2019, the UK passed legislation setting more stringent decarbonisation objectives for 20503. Under the new targets, allgreenhouse gas emissions will need to be net zero by 2050, compared with the previous target to reduce carbon emissions by at least80% from the 1990 levels. This net zero target means that any emissions will need to be balanced by schemes to offset an equivalentamount of greenhouse gases from the atmosphere, such as planting trees or using technology like carbon capture and storage.

Both the government and energy networks have said that achieving these targets will require significant technological andpolicy changes in the energy sector, with the role of natural gas changing on a fundamental basis, including the near completedecarbonisation of heat. Recent research by the UK's Committee on Climate Change shows that a hybrid approach utilising bothelectric and gas solutions may be the most cost-effective way to achieve this objective.

In the short term, SGN has essentially no volume exposure, as any revenue shortfalls due to faster-than-expected declines in demandcan be recovered from customers with a two-year lag. In the longer term, Ofgem has a statutory obligation to “secure” that gastransportation companies “are able to finance the provision of gas supply services.” However, a continued decline in demand for SGN'score service may create challenges for the business which are currently difficult to foresee.

Structural considerationsOur assessment of Southern GN factors in the weaker credit quality of the SGN MidCo group it belongs to. Although SGN MidCo'sfinancing structure includes trigger events, which will restrict dividends and other payments, if consolidated gearing exceeds 85%, thegroup is likely to have very significant headroom in its interest coverage financial covenant. As a result, although the financing structurelimits gearing to levels commensurate with a mid-Baa credit quality for the consolidated SGN MidCo group, it would be possible forcost allowances to decline significantly compared with the company's operating and financing costs, including to levels not consistent


https://www.moodys.com/credit-ratings/National-Grid-Electricity-System-Operator-Ltd-credit-rating-830661156


with the assigned ratings, without triggering this covenant. Despite this risk, we currently regard the credit quality of the SGN MidCogroup to be in the mid-Baa range.

Although this would normally act as a cap on Southern GN's credit quality, the operating company benefits from regulatory ring-fencing provisions, which partly insulates it from the credit quality of SGN MidCo at the current rating level (described in Appendix C,Considerations for ratings within a corporate family,of the Regulated Electric and Gas Networks rating methodology). As a result, thecredit quality of Southern GN is able to pierce that of the SGN MidCo group by one notch.

We consider that the covenant package in the SGN MidCo financing structure insulates the operating companies from shareholderloans at the ultimate holding company, SGN HoldCo. As a result, the debt at SGN HoldCo does not constrain the credit quality of theoperating companies.




Exhibit 11

Debt structure at SGN Midco and operating subsidiaries

Note: Debt list as of February 2020. Index-linked debt shown at book value including accretion as of 31 March 2019.Sources: Company reports, Moody's Investors Service

Liquidity analysisWe view Southern GN's liquidity as good, reflecting the stable and predictable cash flow generated by its regulated gas distributionbusiness that allows it to fund the bulk of its capex and repex requirements, group cash and cash equivalents of £31 million as of 30September 2019, the issue of a £100 million private placement note in November 2019, and its access to a £360 million revolvingcredit facility, which it shares with Scotland GN, not maturing before March 2024.



The next maturity at Southern GN is a £215 million bond maturing in December 2020. Following this, the company has no furthermaturities until 2023.

Rating methodology and scorecard factorsOur assessment of Southern GN’s credit quality is based on the rating methodology for Regulated Electric and Gas Networks,published in March 2017. The scorecard-incidated outcome based on three years of historical financial metrics is A3, and is A3 in ourforward view. The assigned Baa1 rating is constrained by the weaker credit quality of the consolidated SGN MidCo group.

Exhibit 12

Rating factorsSouthern Gas Networks plc

Regulated Electric and Gas Networks Industry Grid [1][2]

Factor 1 : Regulatory Environment and Asset Ownership Model (40%) Measure Score Measure Score

a) Stability and Predictability of Regulatory Regime Aaa Aaa Aaa Aaa

b) Asset Ownership Model Aa Aa Aa Aa

c) Cost and Investment Recovery (Ability and Timeliness) A A A A

d) Revenue Risk Aa Aa Aa Aa

Factor 2 : Scale and Complexity of Capital Program (10%)

a) Scale and Complexity of Capital Program A A A A

Factor 3 : Financial Policy (10%)

a) Financial Policy Ba Ba Ba Ba

Factor 4 : Leverage and Coverage (40%)

a) Adjusted Interest Coverage Ratio (3 Year Avg) 1.6x Baa 1.5x - 1.8x Baa

b) Net Debt / RAB (3 Year Avg) 72.3% Baa 70% - 75% Baa

c) FFO / Net Debt (3 Year Avg) 11.1% Baa 10% - 13% Baa

d) RCF / Net Debt (3 Year Avg) 7.2% Baa 7% - 10% Baa

Rating:

Scorecard-indicated Outcome from Grid Factors 1-4 A3 A3

Rating Lift 0.5 0.5 0.5 0.5

a) Scorecard-indicated Outcome from Grid A3 A3

b) Actual Rating Assigned Baa1

Current

FY 31/03/2019

Moody's 12-18 Month Forward

View

As of February 2020 [3]

[1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations.[2] As of 31/03/2019.[3] This represents Moody's forward view, not the view of the issuer, and unless noted in the text, does not incorporate significant acquisitions and divestitures.Source: Moody's Financial Metrics™

Ratings

Exhibit 13

Category Moody's RatingSOUTHERN GAS NETWORKS PLC

Outlook NegativeIssuer Rating -Dom Curr Baa1Senior Unsecured -Dom Curr Baa1





Appendix

Exhibit 14

Peer Comparison TableSouthern Gas Networks plc

FYE FYE FYE FYE FYE FYE FYE FYE FYE

Mar-17 Mar-18 Mar-19 Mar-17 Mar-18 Mar-19 Mar-17 Mar-18 Mar-19

Revenue 758 746 797 422 411 410 434 425 444

EBITDA 475 438 492 284 268 277 101 311 207

Total Debt 2,630 3,066 2,849 1,363 1,455 1,613 1,574 1,567 1,714

Net Debt 2,623 2,790 2,839 1,354 1,447 1,502 1,503 1,531 1,544

Adjusted Interest Coverage Ratio 1.9x 1.3x 1.7x 2.3x 1.9x 1.7x 1.6x 0.9x 1.1x

Net Debt / Regulated Asset Base 71.9% 73.1% 71.9% 65.4% 67.4% 67.5% 70.9% 70.8% 69.3%

FFO / Net Debt 12.1% 10.0% 11.3% 14.5% 12.2% 12.1% 12.4% 8.5% 10.2%

RCF / Net Debt 6.9% 5.8% 8.9% 7.9% 5.9% 5.9% 9.0% 5.2% 8.0%

(in GBP million)

Southern Gas Networks plc Northern Gas Networks Limited Wales & West Utilities Limited

Baa1 Negative Baa1 Stable Senior Secured - Baa2 Negative

Source: Moody's Financial Metrics™

Exhibit 15

Moody's-adjusted net debt breakdownSouthern Gas Networks plcs

FYE FYE FYE FYE

(in GBP million) Mar-16 Mar-17 Mar-18 Mar-19

As Reported Total Debt 2,514 2,619 3,053 2,837

Leases 4 11 13 12

Moody's Adjusted Total Debt 2,518 2,630 3,066 2,849

Cash & Cash Equivalents (3) (7) (276) (10)

Moody's Adjusted Net Debt 2,516 2,623 2,790 2,839

Source: Moody's Financial Metrics™

Exhibit 16

Moody's-adjusted funds from operations breakdownSouthern Gas Networks plc

FYE FYE FYE FYE


As Reported Funds from Operations (FFO) 427 422 273 325

Pensions 7 10 7 11

Leases 0 1 2 3

Alignment FFO (32) (9) (3) (20)

Unusual Items - Cash Flow (11) (11) (11) (13)

Non-Standard Public Adjustments (108) (95) 11 16

Moody's Adjusted Funds from Operations (FFO) 283 317 278 322

All figures are calculated using Moody's estimates and standard adjustments.Source: Moody's Financial Metrics™



Exhibit 17

Moody's regulatory capital chargesSouthern Gas Networks plc

in GBP millions

FYE

Mar-16

FYE

Mar-17

FYE

Mar-18

FYE

Mar-19

Repex Allowance Classed as Fast Money by the Regulator 71 57 44 31

Regulatory Depreciation 165 166 184 207

Excess Fast/(Slow) Money -2 8 14 8

Operating Leases 0 1 2 3

Moody's Regulatory Capital Charges 234 232 244 249


Exhibit 18

Selected historical Moody's-adjusted financial dataSouthern Gas Networks plcs

FYE FYE FYE FYE


INCOME STATEMENT

Revenue 737 758 746 797

EBITDA 461 475 438 492

EBITDA margin % 62.6% 62.7% 58.7% 61.7%

EBIT 354 362 324 371

EBIT margin % 48.0% 47.8% 43.5% 46.6%

Interest Expense 110 100 102 109

Net income 252 259 184 219

BALANCE SHEET

Total Debt 2,518 2,630 3,066 2,849

Cash & Cash Equivalents 3 7 276 10

Net Debt 2,516 2,623 2,790 2,839

Net Property Plant and Equipment 3,925 4,079 4,250 4,424

Total Assets 5,170 5,316 4,968 4,874

CASH FLOW

Funds from Operations (FFO) 283 317 278 322

Cash Flow From Operations (CFO) 306 280 1,177 296

Dividends 0 135 117 68

Retained Cash Flow (RCF) 283 182 161 254

Capital Expenditures (215) (244) (268) (264)

Free Cash Flow (FCF) 91 (99) 793 (36)

INTEREST COVERAGE

(FFO + Interest Expense) / Interest Expense 3.6x 4.2x 3.7x 3.9x

LEVERAGE

FFO / Net Debt 11.3% 12.1% 10.0% 11.3%

RCF / Net Debt 11.3% 6.9% 5.8% 8.9%

FCF / Net Debt 3.6% -3.8% 28.4% -1.3%

Debt / EBITDA 5.5x 5.5x 7.0x 5.8x

Net Debt / EBITDA 5.5x 5.5x 6.4x 5.8x

Net Debt / Fixed Assets 64.1% 64.3% 65.6% 64.2%

All figures are calculated using Moody's estimates and standard adjustments.Source: Moody's Financial Metrics™



Endnotes1 Ofgem Forward Work Programme 2020-2022 consultation, December 2019

2 Defined as the level of demand that, in a long series of winters, with connected load held at levels appropriate to the winter in question, would beexceeded in one out of 20 winters, with each winter counted only once.

3 UK becomes the first major economy to pass net zero emissions law, 27 June 2019


https://www.ofgem.gov.uk/system/files/docs/2019/12/fwp_programme_2020_22_web.pdfhttps://www.gov.uk/government/news/uk-becomes-first-major-economy-to-pass-net-zero-emissions-law


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