Sector Review:
Can Hong Kong's Power Companies Stay Insulated Against The Cold?
Primary Credit Analyst: Johnson Ng, Hong Kong (852) 2533-3575; [Link]@[Link] Secondary Contact: Gloria Lu, CFA, FRM, Hong Kong (852) 2533-3596; [Link]@[Link]
Table Of Contents
Why Cash Flow Adequacy Could Weaken Investing In Cleaner Fuels May Be A Costly Necessity Competition Is A Distant Threat Strong Profitability Should Be A Future Buffer Related Criteria And Research
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Sector Review:
Can Hong Kong's Power Companies Stay Insulated Against The Cold?
Less comfortable times may lie in store for Hong Kong's two power companies. Over the next five years, the utilities can still expect high returns under the current scheme of control by which they are regulated. But further ahead, uncertainty creeps in. The scheme may not be as favorable when it's renewed in 2019. In addition, the two companies may need to invest in greener assets. And it's possible the market could even open up to competition. Despite these risks, Standard & Poor's Ratings Services believes Hongkong Electric Co. Ltd. and CLP Power Hong Kong Ltd. (CLP) can safeguard their high profitability and industry stranglehold for the foreseeable future. But their credit quality may eventually be jolted. Regulatory risks are rising. Public unease over high living costs led the government to suggest lowering the permitted rate of return during the interim review of the current scheme of control in November 2013. But the mutual consent needed to change the terms wasn't forthcoming from the power companies. We believe the government has sent a clear signal that it will push through the reform for the next scheme. The government is also mulling over changes to its environmental policy to address Hong Kong's chronic pollution problems, and that could prove costly to the utilities. Overview Hong Kong's two power companies can expect strong profitability over the next five years while the current scheme of control is in effect. Longer term, their cash flow adequacy could weaken if the government pushes ahead with reductions to the rate of permitted returns under the next scheme, starting 2019. The companies may also need to invest heavily in transitioning to a cleaner fuel mix. We also see an outside risk that the government may open up the market to new entrants. The utilities are, however, still highly profitable and new entrants would take many years to create any serious competition.
We believe that a lower rate of return and increased leverage to fund a cleaner fuel mix could weaken the cash flow adequacy of Hongkong Electric (A-/Stable/--; cnAA/--) and CLP (A/Watch Neg/A-1; cnAA+/Watch Neg/cnA-1). But the pressure from this risk factor should be containable and many years off. Both companies have deep pockets from operating a de facto duopoly under supportive regulations for more than 40 years. And potential new entrants would take a long time to make any inroad into the Hong Kong market. Any rating actions over the next year will likely be based on company-specific factors. The rating on CLP is on CreditWatch with negative implications because we believe a proposed debt-funded acquisition could weaken the financial strength of its parent company, CLP Holdings Ltd. We lowered the rating on Hongkong Electric to 'A-' from 'A+' on Jan. 29, 2014, because the company's leverage will increase after its spin-off from Power Asset Holdings Ltd.
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Sector Review: Can Hong Kong's Power Companies Stay Insulated Against The Cold?
and when the listing of the group's Hong Kong electricity business is completed. (See the related research listed below.)
Why Cash Flow Adequacy Could Weaken
It's unclear at this stage to what level the government intends to lower the rate of permitted return, and therefore the full impact on the utilities is hypothetical. But, in our view, the cash flow adequacy of both Hongkong Electric and CLP would deteriorate if the rate is lowered, assuming their capital structures remain the same. We expect CLP to be more sensitive than Hongkong Electric to a reduction in the permitted rate of return because CLP has more net fixed assets. Under the current scheme of control, utilities can earn a 9.99% return on their average net fixed assets and 11% return on their average net fixed assets for renewable energy, such as solar and wind power. In 2009, when the current scheme was implemented, the permitted rate of returns fell to 9.99% from 13.5%-15.0%. The decline weakened the cash flow adequacy of both power companies. In the same year, Hongkong Electric adjusted its capital structure by replacing its loan capital with a shareholder's loan, leading to higher leverage. As a result, Hongkong Electric's ratio of funds from operations to debt--a measure of cash flow adequacy--dropped to 25.4% in 2009 from 64.7% in 2008. CLP's ratio fell to 37.0% from 59.5% over the same period (see chart 1).
Chart 1
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Sector Review: Can Hong Kong's Power Companies Stay Insulated Against The Cold?
Investing In Cleaner Fuels May Be A Costly Necessity
We expect Hongkong Electric and CLP to increase their investments in greener generation assets if the government pushes through with its mooted revisions to its fuel-mix policy. Both companies are likely to increase their debt levels to fund the investments, further straining cash flow and leverage. The government aims to reduce Hong Kong's carbon intensity target to 50%-60% by 2020 compared with the level in 2005. We estimate that coal accounts for about half of Hong Kong's power. Under proposals that the government made in 2010, this pollutant would drop to less than 10%. Instead, nuclear energy would account for about 50% of the fuel mix, compared with 23% in 2009. And natural gas would increase to 40% from 23% in 2009. However, the failure of a nuclear plant in Fukushima, Japan, in March 2011, has created public unease over the use of nuclear power. The government has indicated that it will undertake another public consultation on its clean energy policy. Changing the fuel mix to include more gas or nuclear power would be costly. The cost of imported nuclear power from mainland China would be low, but the cost of building a transmission network from China to Hong Kong would be huge. It would also involve a long lead time of eight to 10 years. In addition, increased gas usage would raise fuel costs, and that would intensify the strain on the power companies if they aren't allowed to fully recover the costs through higher tariffs. The Hong Kong government therefore has a difficult decision to make regarding the optimum fuel mix. We believe the power companies may not be able to rely on operating income for the timely recovery of potential investments in a cleaner fuel mix. That's because the utilities are unlikely to be able to raise their tariffs to sufficient levels to cover the costs, given a probable public backlash or government refusal because of the perception that the companies are making outsized profits.
Competition Is A Distant Threat
Opening up the power market to competition could weaken the market dominance of the two power companies in their service areas. The scheme of control doesn't define licensed operating areas for power companies, but in practice Hongkong Electric is the only power supplier to customers on Hong Kong and Lamma islands. And CLP is the only power supplier to customers in Kowloon, the New Territories, and outlying islands such as Lantau and Cheung Chau. Favorable regulations for the power industry and the relatively high profitability in Hong Kong would likely tempt new players to the market. Grid companies in China have already invested there. For example, State Grid International Development Ltd. was the cornerstone investor in the recent public listing of Hongkong Electric. CLP and China Southern Power Grid International (HK) Co. Ltd. have announced they will each acquire 30% stakes in Castle Peak Power Co. Ltd., CLP's sole generation asset in Hong Kong. However, these are all passive investments that won't shake up Hong Kong's power market. We see a low likelihood for the next three to five years at least that the government will further open up the power market in Hong Kong. The market is fairly mature with limited growth potential. Hong Kong is a small market, with an
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Sector Review: Can Hong Kong's Power Companies Stay Insulated Against The Cold?
annual average of just 45,000 million kWh of power units sold over the past five years. We can't rule out the possibility of new entrants, however, given growing public demand for reduced tariffs. Introducing new competition may be one means of driving down electricity fees.
Strong Profitability Should Be A Future Buffer
Hongkong Electric and CLP are likely to have healthy war chests to maintain their market positions and competitive advantages for many years. Both companies have high profitability compared with peers that we rate in developed markets with similarly transparent regulations and predictable profitability. The average return on capital for the two companies was about 12% in 2010-2012, compared with less than 9% for their peers (see chart 2).
Chart 2
Nevertheless, Hongkong Electric and CLP's future profitability will be vulnerable to any changes in the permitted rate of return. And that could affect their credit quality. When the government last lowered the rate in 2009, the profitability of both companies dropped significantly. Hongkong Electric's return on capital fell to 12.4% from 17.6% in 2008 and CLP's to 12.7% from 16.2% (see chart 3).
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Sector Review: Can Hong Kong's Power Companies Stay Insulated Against The Cold?
Chart 3
Investing in cleaner fuels may be costly, but it won't help the power companies to recover more quickly from any dip in profitability under the next scheme of control. Even if the government continues to grant a higher rate of permitted return for renewable energy, such assets comprise less than 5% of the power companies' total generation--too minimal to make an impact. In our opinion, a strong regulatory regime could enable Hongkong Electric and CLP to fully recover their investment costs on a timely basis. And that, in turn, should help the power companies to generate reasonable returns.
Related Criteria And Research
Related criteria
Corporate Methodology, Nov. 19, 2013 Key Credit Factors For The Regulated Utilities Industry, Nov. 19, 2013
Related research
Hongkong Electric Co. Ltd. Rating Lowered To 'A-' From 'A+' On Deteriorating Financial Risk Profile; Outlook Stable, Jan. 29, 2014 CLP Holdings Ltd. And CLP Power Hong Kong Ltd. Ratings Placed On CreditWatch Negative On Proposed
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Acquisition, Nov. 19, 2013
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