Eesti Energia's financial risk profile benefits from the company's currently adequate gearing and credit measures, and ongoing support from the Estonian government, evidenced by a EUR150 million equity injection in July 2012. However, this is offset by our expectation of significant negative discretionary cash flows and a continued gradual buildup of debt as a result of an investment plan to modernize the company's asset base and increase shale oil production.
The ratings do not take into account any large-scale investments in or commitments to possible future nuclear power operations in the Baltic region or oil and electricity production in Jordan.
Our view that there is a "moderately high" likelihood of timely and sufficient extraordinary government support is based on our assessment of Eesti Energia's:
-- "Strong" ownership link, primarily reflecting its 100% ownership by the Republic of Estonia. Although Estonia has been considering privatization of a minority stake in the company, we believe it is unlikely that state ownership would fall below 50%.
-- "Important" role, as the company's operations are strongly aligned with the interests of the state, in particular in its critical role in ensuring Estonia's self-sufficiency in electricity.
S&P base-case operating scenario
In our base-case assessment, we anticipate that Eesti Energia's adjusted EBITDA will increase moderately in 2012 from the EUR242 million recorded in 2011. We believe this increase will be achieved through higher profitability in oil sales thanks to higher prices, higher tariffs in the company's regulated electricity distribution business, and lower carbon dioxide emission costs, the latter as a result of additional free allowances. These factors would more than offset our expectation of lower power sale volumes and lower average power sale prices in 2012, and support a moderate increase in the company's adjusted EBITDA margin from the 29% achieved in 2011.
For 2013, we believe that liberalization and the integration of Estonia's electricity market with neighboring power markets will lead to higher average power prices in Estonia. Currently almost two-thirds of supply market output is regulated and priced low (about EUR30 per megawatt hour (MWh), compared with deregulated prices of EUR35/MWh-EUR45/MWh during the first nine months of 2012). This should, in our view, support Eesti Energia's profitability, which, together with production from a new shale oil plant, should lead to a further increase in EBITDA in 2013.
The magnitude of the increase partly depends on when the new shale oil plant starts production. Following delays, it is now expected to come on stream in first-quarter 2013. We believe, however, that the increase will be limited by declining power volumes and pressure on liberalized power prices as an effect of gradual convergence with Nordic power markets, in which system prices have decreased over the past year. In addition, the company's costs related to carbon dioxide emissions will significantly increase in 2013 as a result of constraints on free emission allowances, although in our base case we assume that Eesti Energia will continue to receive a certain amount of free allowances related to the construction of a power plant, and that carbon prices will remain at a very low level.
Although we believe that higher shale oil sales would contribute to increased earnings, we also believe that this part of the company's operations is higher risk than its electricity operations owing to highly volatile prices (even though the company partly hedges the oil price risk) and exposure to some changes in environmental legislation. There is also execution risk attached to the completion of the company's shale oil investments, as evidenced by the recently announced delay until first-quarter 2013, which ultimately could impact the amount and timing of volumes sold.
S&P base-case cash flow and capital-structure scenario
In our base-case assessment, we assume that Eesti Energia's adjusted funds from operations (FFO) will moderately increase in 2012 from about EUR200 million in 2011. We then expect a further increase in 2013 for the same reasons that we assume EBITDA will increase.
Eesti Energia's significant investment plan, which currently amounts to almost EUR1.5 billion for 2012-2015, and of which about EUR335 million was spent in the first three quarters of 2012, is resulting in materially negative discretionary cash flows and gradually increasing adjusted debt. We adjust debt for surplus cash in excess of EUR25 million, as well as limited pension liabilities, asset retirement obligations, operating leases, and guarantees. This development is likely to have a negative impact on the company's credit measures in 2012, despite the equity injection of EUR150 million by the government in July 2012. We forecast that for 2012, adjusted FFO to debt will fall to about 35% (41% in 2011) and adjusted debt to EBITDA will increase to about 2.5x (2.0x in 2011), These ratios are still in line with our expectations for the SACP, which, based on the current business risk profile, includes adjusted FFO to debt of above 30% and adjusted debt to EBITDA of below 3.0x.
In our base case, we assume that Eesti Energia will continue to arrange long-term funding and obtain further equity contributions or similar from the Estonian state to fund its investment plan. We believe that further equity contributions will likely be necessary to maintain credit measures in line with the SACP if the company chooses to expand its investment plan. We note that the company has some flexibility in reducing or partly postponing its investment plan if it negatively revises its forecasts for operating cash flows or equity contributions.
We consider Eesti Energia's liquidity to be "adequate" as our criteria define this term. This is based on expected cash resources (including FFO) amounting to more than 1.2x of cash outflows over the next 12 months, adequate headroom under financial covenants, and sound relationships with banks.
The company's main liquidity resources are as follows:
-- As of Sept. 30, 2012, the company had EUR232 million in cash and equivalents, and full availability under five committed bilateral revolving credit facilities amounting to EUR500 million. In October 2012, the total amount of the facilities was reduced to EUR400 million. The facilities mature in September 2014 and have no restrictive financial covenants.
-- The company has access to EUR95 million through long-term loan agreements with the European Investment Bank for financing certain investments. These loans can be drawn upon until December 2012.
-- We assume that FFO will be clearly in excess of EUR200 million in 2012, and increase further in 2013.
Expected cash outflows consist of:
-- Minor debt maturities of about EUR3 million over the next 12-24 months (as of October 2012).
-- Capital expenditures of about EUR570 million in 2012, and a slightly lower amount in 2013.
-- Dividends of about EUR65 million annually, in line with the amount paid out in 2012.
In line with a EUR300 million bond issue in the first quarter of 2012, we further assume that Eesti Energia will continue to arrange long-term funding well in advance to fund its investment plan. Part of Eesti Energia's loan documentation is subject to covenants relating to the company's financial performance. We anticipate that the company will continue to have adequate headroom under these covenants over the near term. Documentation relating to two bonds, totaling EUR600 million, contains a put option linked to a reduction of government ownership to less than 51% and a subsequent downgrade to speculative grade.
The stable outlook reflects our assumption that Eesti Energia 's SACP and the "moderately high" likelihood of extraordinary government support will remain unchanged over the near term.
In our base case, we assume that the company's SACP will remain unchanged. We base this assumption on our expectation that Eesti Energia will benefit from higher average power prices and successful completion of shale oil investments, which should result in increased earnings contributions. We further expect continuing support from the Estonian government, partly through additional equity contributions, if needed, to fund the company's expansionary investments. These factors should help Eesti Energia to maintain credit measures in line with the rating. We consider a ratio of adjusted FFO to debt of more than 30% and a ratio of adjusted debt to EBITDA of less than 3x to be consistent with the 'bbb' SACP, provided there is no change in Eesti Energia's business risk profile.
In line with our criteria for government-related entities, we would lower the rating by one notch if we revised the company's SACP downward by two notches, i.e., to 'bb+', assuming the likelihood of extraordinary support and our long-term rating on the Republic of Estonia both remained unchanged.
The SACP could come under pressure if we see a weakening in the company's business risk profile, for example as a result of a continued decline in deregulated wholesale power prices or shale oil prices, a significant decline in the company's domestic power market share, or unsuccessful completion of ongoing investment projects. A weaker business risk profile could lead to a review of the credit measures we expect for the SACP. The SACP could also come under pressure if the company does not secure timely long-term funding for its investment plan, including contributions or similar from the government, and if this in turn were to cause the company's credit measures or liquidity position to weaken beyond our expectations for the rating.
We could lower the rating if we lowered the rating on the Republic of Estonia or if we were to revise our assessment of the likelihood of support to "moderate", but in both cases, only if this were accompanied by our downward revision by at least one notch of Eesti Energia's SACP. We could lower our assessment of the likelihood of support if the government were to cease to be the majority owner of the company.
We currently see limited upside rating potential, as the company's investment program and challenging industry conditions are likely to prevent any upward revision of the SACP in the near to medium term. Any upgrade of the Republic of Estonia or a higher assessment of the likelihood of extraordinary government support could lead to an upgrade. However, this is currently unlikely.