Morningstar DBRS Confirms Eesti Energia AS' Issuer Rating at BBB (low) With a Stable Trend

DBRS Ratings GmbH (Morningstar DBRS) confirmed its Issuer Rating on Eesti Energia AS (EE or the Company) at BBB (low) with a Stable trend.

KEY CREDIT RATING CONSIDERATIONS
EE's leading position in Estonia's electricity market supports its credit rating. The Company's activities include power generation and sales, along with electricity distribution through the ownership and operation of the low- and medium-voltage grid covering 95% of the Estonian territory. Electricity distribution is a regulated business and as such provides the Company with more stable revenues and earnings. Furthermore, given (1) the relative importance of EE to the Estonian economy, (2) the essential service that it provides to the Estonian population, and (3) the Company's 100% state ownership, Morningstar DBRS believes that the Estonian state would be highly incentivised to provide financial support to the Company in the event of distress. For this reason, Morningstar DBRS has assigned a two-notch uplift based on the Estonian state's implicit support relative to the Company's stand-alone credit rating.

Conversely, the Company's limited geographical diversification constrains the credit ratings, considering that 96% of its revenue comes from the Baltic states and Poland. The high carbon intensity of EE's oil shale operation also poses risks on several fronts. EU policies restrict its member states' carbon emissions, which limits the Company's ability to use its oil shale-fuelled plants at full capacity. In order to compensate for this and to reduce carbon emissions, the Company needs to make large capital expenditures (capex) on renewable project developments and to refit the oil shale-fuelled power plants. Lastly, Morningstar DBRS considers that the Company's financing conditions are more challenging. In Morningstar DBRS' view, the Company's elevated carbon emissions could temper investors' interest in providing funding at the parent company level. This situation was made apparent based on the conditions set forth in the syndicated loan that was signed in February 2023. The variable rate component of this loan increased the Company´s gross debt exposed to changes to the interest rates from 31% in 2022 to 88% in 2023, also the loan includes semi-annual repayments accounting for half of the debt issued instead of the bullet maturity of the instrument this loan was used to repay.

In 2023, EE deteriorated almost the entire value of its oil shale power assets, as producing electricity from these facilities given the expected market prices would have been unprofitable. Average electricity prices in the Baltic states fell from an average between EUR 90 per megawatt hour (/MWh) and EUR 95/MWh throughout 2023 to around EUR 82/MWh in H1 2024, leading to a last 12 months ended June 2024 revenue reduction of 10.0%. For the same comparative periods, EBITDA generation remains practically unchanged; however, H1 2024 included a EUR 62 million positive one-off profit related to carbon emission allowances received free of charge in the period. Excluding this, comparative EBITDA would have declined by 13.0%. In Q1 2024, the Company's net leverage reached 3.8 times (x), above EE's medium-term guidance of 3.5x. Morningstar DBRS notes that this ratio did improve to 3.2x (3.0x adjusted) in Q2 2024, during the time of the semi-annual covenant calculation.

CREDIT RATING DRIVERS
Morningstar DBRS would consider a positive credit rating action if the EBITDA contribution from the distribution activity increases to more than 40% on a sustained basis given no adverse material changes in any of the activity's Business Risk Assessment (i.e., adverse regulatory changes). An upgrade may also be possible if the Morningstar DBRS-adjusted cash flow-to-debt ratio migrates to well above 30% on a sustained basis. Conversely, Morningstar DBRS could take a negative credit rating action if the Company's EBITDA contribution were to fall below the 20% threshold over the medium term, reducing the stability of cash flows. A reduction in contracted revenues, limiting the predictability of cash flows, will be seen as credit negative. Morningstar DBRS could also downgrade EE's credit rating if it were to downgrade its sovereign credit rating on the Republic of Estonia.

EARNINGS OUTLOOK
Morningstar DBRS estimates that revenues will slow by YE 2024 as realisation prices are lower compared with those in 2023. Despite the expected decline of electricity market prices to EUR 80/MWh, revenues should start to improve in 2025 as volumes increase based on the new renewable capacity becoming operational. Over the next few years, no material change is expected regarding the electricity output from the oil shale-powered facilities in comparison with the 2.3 TWh generated in 2023. Morningstar DBRS based this consideration on the estimated electricity future prices along with the cost of carbon emission allowances.

FINANCIAL OUTLOOK
Morningstar DBRS expects the Company's overall credit risk profile and its key credit metrics to deteriorate in 2024 and 2025, driven mainly by the large capex planned as part of the Company's 2022-26 updated strategic plan to reach 1,700 MW of renewable energy capacity and to refit its oil shale power plants. In the regulated business, additional investments are needed to weatherproof the electric grid. Morningstar DBRS deems the expected cash flow generation during the investment period to be insufficient to cover the capex requirements; therefore, the Company will need to raise additional debt to make up for the expected cash flow shortfall. In July 2024, EE issued EUR 400 million in hybrid debt at an initial fixed interest rate of 7.875%. This will raise the average interest costs and cause interest coverage-related metrics to weaken. In spite of the weakening in credit metrics, Morningstar DBRS estimates that the key financial metrics will remain within the Company's current credit rating category.

CREDIT RATING RATIONALE
The following key factors support EE´s Issuer Rating: (1) a leading position in its domestic market; (2) the Company's regulated distribution activity, which provides profit stability; and (3) implicit sovereign support from the Estonian state. However, the Company's Issuer Rating is constrained by: (1) EE's limited geographical footprint, (2) reduced electricity output from oil shale-fuelled power facilities, (3) the high capex requirements over the coming years, and (4) limited financing flexibility at the parent company level. The Stable trend reflects Morningstar DBRS' view that EE´s credit metrics will remain supportive of a BBB (low) Issuer Rating in the foreseeable future.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Environmental (E) Factors

The following Environmental factor had a significant effect on the credit analysis: carbon and greenhouse gas costs. The high carbon intensity of the Company's power plants requires it to purchase many carbon emission allowances, making operating the facilities unprofitable at certain electricity market prices.

There were no Social or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August 2024) at https://dbrs.morningstar.com/research/437781.

BUSINESS RISK ASSESSMENT (BRA) AND FINANCIAL RISK ASSESSMENT (FRA)

(A) Weighting of BRA Factors
In the analysis of EE, the BRA factors were considered in the order of importance contemplated in the methodology.

(B) Weighting of FRA Factors
In the analysis of EE, the FRA factors were considered in the order of importance contemplated in the methodology.

(C) Weighting of the BRA and the FRA
In the analysis of EE, the BRA carries greater weight than the FRA.

Notes:
All figures are in euros unless otherwise noted.

Morningstar DBRS applied the following principal methodology:
-- Global Methodology for Rating Companies in the Regulated Utility and Independent Power Producer Industries (27 June 2024), https://dbrs.morningstar.com/research/435127

Morningstar DBRS credit ratings may use one or more sections of the Morningstar DBRS Global Corporate Criteria (15 April 2024; https://dbrs.morningstar.com/research/431186), which covers, for example, topics such as holding companies and parent/subsidiary relationships, guarantees, recovery, and common adjustments to financial ratios.

The following methodology has also been applied:
-- Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August 2024), https://dbrs.morningstar.com/research/437781.

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

A description of how Morningstar DBRS analyses corporate finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/431153.

The primary sources of information used for this credit rating include annual reports and interim company presentations from EE and Enefit Green, electricity market information, Estonian and EU regulatory documents and bond prospectus. Morningstar DBRS 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

Morningstar DBRS 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. Morningstar DBRS trends and credit ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/439559

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: 25 September 2023
Last Rating Date: 25 September 2023

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on https://dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

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