DBRS Morningstar Assigns an Issuer Rating of BBB, Stable Trend, to Latvenergo AS

DBRS Ratings GmbH (DBRS Morningstar) assigned an Issuer Rating of BBB with a Stable trend to Latvenergo AS (Latvenergo or the Company).

CREDIT RATING RATIONALE
Latvenergo’s Issuer Rating is supported by the following key factors: (1) market-leading position in its home market, (2) the regulated electric distribution activity is set to provide cash flow stability over the long term albeit there was significant volatility in recent years which we however expect will reduce as new tariffs align with the energy market prices, and (3) the implicit sovereign support from Latvia (Latvia; rated “A” by DBRS Morningstar with a Stable trend). However, the following factors constrain Latvenergo´s Issuer Rating: (1) limited geographical and technological diversification, (2) The distribution business regulatory framework allows for a limited return on equity, and (3) expansion plans will require high capital expenditures above the group’s own cash generating capacity. The Stable trend reflects DBRS Morningstar’s view that Latvenergo´s credit metrics will remain supportive of a BBB Issuer Rating for the foreseeable future.

KEY CREDIT RATING CONSIDERATIONS
Headquartered in Riga, Latvia, Latvenergo is the largest producer of green electricity in the Baltics, accounting for 24% of total green generation in the region. From the Company´s total of 3.8 terawatt hours (TWh) generated in 2022, 70% was produced from hydro. The Company´s 2.6 gigawatts (GW) installed capacity accounts for about 90% of the total installed capacity in Latvia, consisting of 1.6 GW hydro and 1 GW cogeneration. Sadales Tikls AS, wholly owned subsidiary, owns and operates a grid that extends for 92,407 kilometers consisting of medium and low-voltage lines and is the country´s largest Distribution System Operator (DSO) covering 99% of Latvia; this segment is a regulated business. Through its commercial brand Elektrum, Latvenergo supplies electricity and gas in the Baltics to more than 800,000 customers, concentrating a 50% market share in Latvia and 10% and 9% in Lithuania and Estonia, respectively.

The credit rating is supported by (1) Latvenergo´s market-leading position in its home market. The Company´s generation business holds 90% of the country´s installed capacity and, in 2022, generated 84% of the total electricity produced in Latvia and 23% of all the Baltics electricity. Latvenergo is also the largest producer of green energy in the Baltics given its hydro assets´ capacity. Latvenergo is the sole owner of the leading DSO in Latvia. On its supply business side, the Company accounts for 50% of the market share in its home country. (2) The regulated electric distribution activity is set to provide cash flow stability over the long term. Carried out by the Company´s wholly owned subsidiary, Sadales Tikls AS, Latvia´s largest DSO is covering 99% of the national territory. DBRS Morningstar considers that despite the recent electric price volatility as a consequence of the Russia-Ukraine conflict, as new tariffs incorporate the recent market prices, this will stabilize cash flows contribution from its DSO acitivties,. (3) Latvenergo´s implicit sovereign support given the 100% ownership by Latvia Our support assumtion is supported by the essentiality of the services provided to the Latvian population and the importance of its operation in terms of electricity output as an economic resource for the country. For these reasons, DBRS Morningstar assigns an uplift with respect to the Company´s stand-alone credit rating.

Conversely, the credit rating is constrained by the Company’s (1) limited geographical and technological diversification, 99% of Latvenergo´s installed capacity is composed of hydroelectric and cogeneration facilities, which are all located along the Daugava river. This river flows from Russia and Belarus before reaching Latvian territory and disruption risk given the geopolitical tension in the region is in our view mitigated by Latvia´s membership in the EU and NATO. Historically, the river flow has been volatile so the hydro output will remain dependent on the hydrological fluctuations. (2) The distribution business regulatory framework allows for limited return on equity. Although DBRS Morningstar considers that the regulation framework governing the electric market in Latvia is relatively strong and in line with its Baltic peers, the Latvian regulator currently allows for a limited Return on Equity over the Regulated Asset Base, which is far lower compared with Estonia and Lithuania. In addition , the profitability of the DSO has been negative over recent years, although, some recovery in profitability over the next years can be expected. (3) Expansion plans will require high capital expenditures asthe Company plans to increase its renewable capacity. According to its 2022–27 plan, the Company will spend EUR 1.7 billion in investments for both the generation and electric grid businesses. The amount planned is significantly above the average investments made in the recent years, which will lead to a deterioration of its financial metrics over the next years. In addition, DBRS Morningstar notes that Latvenergo has very limited experience in developing wind and solar renewable projects. So far only 9 megawatts (MW) of its total installed capacity is related to assets other than its main CHPPs (cogeneration) and HPPs (hydro). We acknowledge that the Company will strategically participate with more experienced partners through joint ventures, along with potentially acquiring brownfield assets. However given the Company´s limited experience as a developer, execution will remain a risk.

Latvenergo´s performance in 2022 was driven by several factors: the increase in average electricity price by 118% to EUR 136 per MWh, and the output stability of the HPPs at 2.67 TWh, similar in comparison to 2021. However CHPPs´ output was cut by 39% given the gas price increasing more than twofold. Overall these factors interaction caused the Generation & Trade segment´s revenue to increase by more than 100% as well as the EBITDA in this segment to increase from EUR 80 million to EUR 275 million. Regarding the Distribution business, the EBITDA fell by 33% given the 3.5% lower distributed volume because of warmer weather conditions and the lower tariffs still in place. EBITDA contribution from the Distribution business was 20%, diverging from our forward looking medium-term contribution set at 35%. The Generation & Trade segment´s nine-month 2023 results reflect 20-year record hydro output reaching almost 4 TWh in this period, which contrasts with the 2.7 TWh over the same period in 2022. Despite the average electricity falling by 59% in the region, the Distribution segment´s EBITDA increased by 132% compared with the same period in 2022. During the first nine months of 2023, the distribution business improved its EBITDA by 35% as higher tariffs have been applied since July 2023.

CREDIT RATING DRIVERS
DBRS Morningstar estimates that on average over the medium term, 35% of the EBITDA contribution will be related to the Company´s regulated activities underpinning the stability of the credit rating; however, relevant deviations from this average contribution can occur during a single year given the river flow volatility impacting the power output of the Company´s HPP facilities. Although the credit rating is expected to remain stable, DBRS Morningstar could take negative credit rating actions if the contribution from the regulated activity, which is considered more stable compared to the Generation & Trade activity, were to approach 20% over the medium term on a sustained basis. Adverse regulatory changes, a downgrade of the sovereign credit rating of Latvia or a change on the perceived implicit support may trigger a downgrade. Conversely a positive credit rating action could be taken if the Business Risk Assessment improved by either higher diversification, a longer price hedging strategy combined with the incorporation of purchase power agreements or a medium-term improvement in the operating efficiency of the DSO business.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Environmental (E) Factors
There were no Environmental factor(s) that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factor(s) that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factor(s) that had a relevant or significant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” (4 July 2023) https://www.dbrsmorningstar.com/research/416784.

Notes:
All figures are in euros unless otherwise noted.

DBRS Morningstar applied the following principal methodologies:
-- Global Methodology for Rating Companies in the Independent Power Producer Industry (9 May 2023) https://www.dbrsmorningstar.com/research/413646
-- Global Methodology for Rating Companies in the Regulated Electric, Natural Gas, and Water Utilities Industry (27 September 2023) https://www.dbrsmorningstar.com/research/421106

The following methodology has also been applied:
-- DBRS Morningstar Global Criteria: Guarantees and Other Forms of Support (28 March 2023) https://www.dbrsmorningstar.com/research/411694

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

A description of how DBRS Morningstar analyses corporate finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/397223.

The primary sources of information used for this credit rating include audited financial statements, quarterly results reports and presentations, presentation transcripts, and publicly available regulatory information. DBRS Morningstar considers the information available to it for the purposes of providing this credit rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third-Party Participation: NO
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar trends and credit ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/425576.

This credit rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Pablo Santin, Assistant Vice President
Rating Committee Chair: Anke Rindermann, Managing Director
Initial Rating Date: 21 December 2023
Last Rating Date: Not applicable as there is no last rating date.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com or contact us at [email protected].

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