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Finance & Investment Ratings agency view Scott Phillips not generators. Under the proposed CfD supplier obligation, the generators will bear the risk that the counterparty is not paid in time under the pay when paid provision. The most recent draft of the Energy Bill makes provision for a reserve account, to which uppliers would have to contribute, s to meet any shortfall arising from a supplier insolvency. There are also other means of dealing with supplier insolvency, including collateral, the energy supply company administration arrangements and the supplier of last resort regime, which the government feels will ensure that payments continue to be made. The latest policy update on the supplier obligation also makes reference to a mutualisation process, but we will have to wait for further detail on how this would work. However, as long as the pay when paid provision remains in place, the risk of supplier payment default and insolvency leading to a shortfall in the funds available to the CfD counterparty remains on the generator, whatever other arrangements are in place. The level of payments to be made by suppliers under the supplier obligation has been the subject of recent consultation. Under the Renewables Obligation, the annual obligation was fixed in advance, whereas the payments under each CfD will vary according to the variations in the reference price and in generation levels. This will be particularly acute for intermittent generation such as wind where the reference price will be day ahead. The CfD counterparty will not know how much it will need to pay out under each CfD in advance. Clearly, suppliers will be keen to keep v olatility in their payment obligations to a minimum, while the CfD counterparty will want to minimise its exposure to volatility under the CfD. Industry responses strongly favour a fixed payment obligation, and the government will work on this over coming months. Much has been made of the risks faced by generators under the CfD regime, but it is also the case that licensed suppliers will see their own risk profiles changing under the new supplier obligation. Suppliers have the ability to pass costs through to consumers, but the government is keen to keep costs to consumers as low as possible. There are also acknowledged concerns about the effect of the supplier obligation on smaller, independent generators, and the possible increase in vertical integration in the market as vertical integration will allow access to the "natural hedge" between generation and supply. Elisabeth Blunsdon, of counsel at Hogan Lovells LLP ROCs BY the NUMBERS 0.206 Number of ROCs a supplier is obliged to purchase for every MWh supplied to customers in 2013/14 0.244 Number of ROCs a supplier is obliged to purchase for every MWh supplied to customers in 2014/15 £42.02 Buyout price per ROC a supplier has to pay for any shortfall, 1 April 2013 to 31 March 2014 87p Effective price per kWh supplied "Regulated utilities will receive lower overall revenue but will still pay nominal interest rates, making them more reliant on external borrowing" S ince the peak of the financial crisis in 2008-09, the cost of borrowing for UK regulated utilities has fallen dramatically, driven predominantly by the Bank of England's quantitative easing programme. Whereas a typical water or energy network company was borrowing at 7 per cent five years ago, that is now closer to 4 per cent. Given their large investment programmes, surely such an environment in the debt market should be positive for these companies? In research published last week, however, we argue that two potentially negative credit issues could arise for the sector if such benign conditions persist. First, historical funding choices will come under increased scrutiny. Prior to the financial crisis, the model for acquiring regulated water and network utilities was straightforward – high leverage coupled with long-dated debt, often within a restrictive financing platform. In this way, shareholder returns could be maximised without credit ratings being unduly affected. The potential problem is that the historical time period considered by Ofgem and Ofwat when setting the allowed rate of return is somewhat shorter than the tenor of debt issued by some of these utilities. This means that the recent falls in interest rates will feed through into their regulatory revenue more quickly than into their actual cost of debt. Economically speaking, the value of this debt has increased significantly and for some companies has almost eroded the equity buffer within their capital structure. According to our analysis, Southern Water and Wales & West Utilities are the two most exposed utilities, whereas Northern Gas Networks and United Utilities – who have historically taken a more cautious approach to their financing – appear better positioned relative to their sector peers. Second, liquidity would be negatively affected under the current regulatory regime. Under the RPI-X framework, regulated utilities are given a real return (i.e. excluding inflation) on their asset base, but in contrast fund themselves primarily with vanilla fixed-rate bonds that do include an inflation element. This results in a mismatch. In a sustained low real interest rate environment, regulated utilities will receive lower overall revenue (as returns will fall) but will still pay nominal interest rates, making them more reliant on external borrowing to plug the gap. In a normalised macro environment this shouldn't be a problem for UK utilities as their inflated asset base creates additional capacity to borrow. Moody's believes, however, that it will be important for ratings stability for companies to demonstrate adequate internal sources of liquidity to manage external shocks and that to achieve this, some may need to deleverage. Scott Phillips, Moody's Investors Service UTILITY WEEK | 18th - 24th October 2013 | 19