Here, S&P Global Ratings answers questions from market participants about the potential credit consequences of the coronavirus pandemic on our rated Spanish operators of natural gas networks. Also sparking questions is our recently revised our view about the credit quality of these distribution system operators (DSOs) under the new regulatory period starting in January 2021 and running through 2026, according to Spain's final remuneration framework published on April 3, 2020 (see "S&P Global Updates Its View On Spanish Gas Distribution System Operators," published on Feb 17, 2020.) Finally, we also respond to queries about the long-term picture for DSOs as Spain transitions its energy mix to greener fuels.

Frequently Asked Questions

Are DSOs exposed to a decline in revenue stemming from drops in demand?

Yes, but we believe it is limited due to the regulatory framework. Spain's remuneration methodology includes two main elements: a fixed component, which accounts for the base remuneration, and a variable component, which is a function of incremental connection points (new customers) and fluctuations in gas demand. This means that Spanish gas DSOs have exposure to fluctuations in gas demand. We see this as a relative weakness of the Spanish regulatory framework compared with other European frameworks that do not expose operators to demand swings.

As of March 2020, quarterly gas demand in Spain dropped 2% from the same period in 2019. Industrial gas demand, which represents about 60% of the total in Spain, faced a similar drop in the same period. So far, this has flattened growth in gas consumption (see chart 1). However, due to the economic impact of the pandemic, we expect even deeper declines in April through June, and a bottom in May, resulting in an average drop of 10% in total gas demand for the second quarter, compared with second-quarter 2019. In turn, S&P Global Ratings estimates this could reduce annual demand 4%-5% in 2020, assuming consumption starts picking up in July and recovers only gradually.

Chart 1

We expect the declines in industrial gas demand to be manageable for the DSOs, even if the drop is roughly twice as pronounced as we currently expect (where gas consumption rebounds in July). We estimate that, all other things equal, a drop of 10% in industrial demand would shave off at most 3% in EBITDA for our rated DSOs.

We note that residential demand is typically more resistant to economic downturns, and the months with higher demand are usually November through March. This means that the drop in residential gas demand starting in April is probably more seasonal than episodic, that is, related to the pandemic. This is why we don't expect any material swings in financial performance stemming from residential demand for the rated DSOs.

Table 1

We expect Nortegas and Redexis, which have more exposure to industrial volumes, to be more sensitive to the economic downturn than Madrilena Red de Gas, whose customer base is mostly residential. Yet, we think this sensitivity will remain manageable in the short term.

Nedgia, Naturgy's gas DSO subsidiary, is also exposed to industrial demand mainly due to its nearly 100% market share in gas distribution in Catalonia and Comunidad Valenciana, regions that account for close to 40% of Spanish gas distribution industrial demand. We therefore see Nedgia as having the same sensitivity as the rest of the sector, with a drop in EBITDA of at most 3% in the event of a 10% drop in industrial demand. However, we see this impact as limited for the consolidated Naturgy group (less than 1.5% of consolidated EBITDA) and less significant than for its LNG commercial activities given low gas prices and declining gas demand in Europe.

We believe that, amid economic turbulence, distributors with a larger residential customer portfolio would benefit from more stable gas consumption than distributors that are more sensitive to industrial demand. In addition, domestic demand is remunerated at €7.5 per megawatt-hour (MWh), while industrial demand is at €1.25/MWh. However, we recognize that industrial customers provide more sources of growth over the medium term than residential ones, particularly because of the bridge role that gas plays in Spain's energy policy to decarbonize industry.

Table 2

With the gradual easing of confinement measures, nonessential plants will slowly go back to production. With this, industrial gas demand should start to recover. However, as elsewhere in Europe, we assume the easing of lockdowns will be slow and selective, and subject to sudden tightening if infection rates rebound. Despite the large degree of uncertainty, the longer it takes to contain the virus, the harsher the impact for industrial activity and therefore gas demand.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

What are other operational risks facing Spanish DSOs?

We see additional risks stemming mainly from liquefied petroleum gas (LPG) activities, which are regulated in purchase and sale price but exposed to retail activities, and lower growth prospects due to reduced commercial activity.

The DSOs' exposure on the LPG side of its business is larger in relative terms but not in absolute terms because it is a minor share of EBITDA. This mainly involves commercial LPG sales where there could be some delays in collections and nonpayments of debt, depending on the duration and depth of the downturn. However, these sales are mostly domestic, and, as a result, inherently less sensitive to recession than industrial demand. Moreover, we estimate that margins for nonregulated LPG sales are on average close to 20%-25% as opposed to 75% for regulated activities, which means that exposure to this segment would have less of a financial impact than for regulated activities.

Table 3

As such, we estimate that, all other things equal, a 10% drop in annual LPG demand would result in a marginal decline in EBITDA for all DSOs-- below 0.5% of EBITDA or less than 5 basis points in terms of funds from operations to debt.

Another operational risk is the likely delay in the deployment of new connection points because of the current pause in door-to-door commercial activity. We expect that the companies will push capital expenditure allocated to this segment toward next year. This could potentially hold back growth in 2020 and therefore slightly depress EBITDA for the year compared to the budget.

We see counterparty risk as limited, since all gas suppliers, which represent the main counterparty risk for DSOs, must provide a letter of credit that covers their gas orders in order to operate. If one supply company defaults on its obligation to the DSOs, the letters of credit would fund the pending payment. In our opinion, this mitigates counterparty risk.

What actions has the Spanish government taken on behalf of gas DSOs?

The Royal Decree 11/2020 published on April 1, 2020, states that the Spanish government will compensate the system for revenue shortfalls stemming from the measures adopted during the country's state of alarm. This is applicable to the gas sector in general, including our rated DSOs.

During the state of alarm, end customers can ask gas suppliers to suspend billing at no cost, and suppliers are not allowed to suspend gas supply. In turn, gas suppliers can delay payment to gas distributors at the earliest between the collection of payment from the customer or at most for six months after the conclusion of the state of alarm. The Spanish government will guarantee shortfalls resulting from billing suspensions, thereby lessening cash flow risks for the DSOs.

Another temporary measure adopted by the Spanish government is to allow end consumers to adjust their access tariffs, which correspond to various gas consumption levels, at no cost. This adjustment, otherwise fixed for the year, could reduce regulatory revenues for DSOs. However, as outlined in the royal decree, the Spanish government will compensate the system, and therefore the DSOs, for any resulting shortfall in regulated revenues, by granting a credit guaranteed by the Spanish government to the CNMC, the Spanish regulator, which in turn will compensate the system.

We don't expect substantial shortfalls in regulated revenues under this measure. Even if they are, we estimate they would result in temporary dips in working capital, most of which would be recovered before the end of the year.

Would shortfalls in regulated revenues add to the tariff deficit?

Yes, but we see this effect as largely transitory. Gas system revenues come almost entirely from toll payments for grid operators. The DSOs have a fixed component, which is currently subject to adjustment during Spain's state of alarm, and a variable component, which depends on consumption. As we explained above, the Spanish state will cover any shortfall in system income from the first component. Shortfalls resulting from declines in the second component will be absorbed in the form of a tariff deficit by the system.

Before the pandemic, the gas tariff deficit was trending toward balance. In fact, the Spanish gas system generated a surplus of €30 million in 2018 and an even larger surplus of €354 million in 2019. We believe that this trend could potentially offset any potential sharp increase in the tariff deficit for 2020 caused by a drop in demand.

Chart 2

Tariff deficits represent a legal payment obligation for Spanish DSOs, which have securitized such deficits in the past to realize collections ahead of schedule, mitigating cash flow mismatches.

What is our current view of the credit quality of Spain's regulated gas sector?

We believe their credit quality should prove to be resilient to economic fallout from the pandemic, for reasons that we also explain above. DSOs should see only a limited decline in the volumes of gas they distribute. In addition, we have visibility about remuneration for the regulatory period starting in January 2021 and running until December 2026, which was approved last month.

The CNMC approved the final remuneration methodology on April 3, 2020, which allows the dust to settle on a regulatory review that we viewed as disruptive (see "S&P Global Updates Its View On Spanish Gas Distribution System Operators," published on Feb. 17, 2020). In our opinion, this methodology provides a stable operating environment for the DSOs for the six years starting in 2021.

Rated Spanish gas networks include Enagas (transmission); and Naturgy, Redexis, Nortegas and Madrilena Red de Gas (primarily distribution). Following the recent approval of the remuneration methodology for gas distribution, despite a decline in remuneration, in most cases, the DSOs' disciplined financial policies will partly offset the lower earnings during in the next regulatory period. All rated issuers in the sector therefore remain investment grade. However, we believe that the sector, to maintain its creditworthiness, might need to gradually reduce debt in the next regulatory period to lessen long-term risks.

In general, we believe the cut in remuneration for DSOs will have less of an effect on Redexis and Naturgy. Redexis' strategy will allow it to more than compensate via organic growth, unlike other DSOs. This follows the company's recent investment strategy and geographic footprint, allowing for greater gas penetration prospects over the next regulatory period.

Naturgy has a 75% market share of the gas distribution sector in Spain through its subsidiary Nedgia, which posted EBITDA of €935 million for 2019 or about 20% of the group's total EBITDA. Nedgia's preliminary remuneration cut as a share of EBITDA is close to 17% but only about 4% of consolidated EBITDA, and therefore is less significant for the group's consolidated credit quality. We believe the impact over the next regulatory period is manageable because of the company's diversified sources of EBITDA, which mitigates a declining EBITDA trajectory for the Spanish gas distribution segment.

Table 4

For Madrilena and Nortegas, the cut is more substantial in terms of EBITDA by 2026 (see table 4). We believe Nortegas will adjust its dividends over the next regulatory period to protect the investment-grade rating, in line with the group's financial policy, along with some initiatives to boost organic growth. By contrast, even though the preliminary cut in remuneration for Madrilena is less than the disruptive one from July 2019, we think the company could struggle to retain credit metrics consistent with the 'BBB' rating, given its track record of aggressive dividends, all other things equal. We still lack clarity about Madrilena's financial policy and willingness to protect its current rating. This explains why the outlook on the rating on Nortegas is stable and Madrilena is on CreditWatch with negative implications (see "S&P Global Updates Its View On Spanish Gas Distribution System Operators," published on Feb. 17, 2020).

The new regulatory period will lower the EBITDA contribution of Spanish regulated activities for Enagas. In addition, we see an increasing exposure to dividends upstreamed from the equity investments on unregulated midstream activities. We expect Enagas to offset a weaker business mix by improving its credit metrics in 2021 and 2022 (see "Spanish Gas TSO Enagas Outlook Revised To Stable On Final Regulatory Determination, Despite Weakening Business Risk," published on Nov. 28, 2019).

What is our longer-term view about Spain's gas infrastructure sector?

We see a longer-term risk of disruption for the industry. Although we still see gas as relevant amid the energy transition, demand in Spain could moderate toward the end of the decade so that the country can reach its environmental targets, which, in our opinion, raises uncertainties about the industry's prospects. Therefore, the industry's medium- to long-term challenge is to find new sources of growth. Unlike in other countries, DSOs' gas network remuneration for in Spain has a demand component, leaving gas distributors more exposed to a drop in gas consumption. There are technologies that could reinforce the prospects for gas infrastructure such as hydrogen or renewable gases, such as biomethane, but their commercial potential is not yet clear. Therefore, disruption risk is one factor that could influence our perception about the companies' business risk profiles over the medium term. This is even more relevant for undiversified companies.

More positively, unless there are changes to national energy plans resulting from the ongoing crisis, we see the role of gas in the energy transition as more relevant over the medium term than for other fossil fuels in Spain. We base our view on Spain's updated National Energy and Climate Plan (PNIEC) of January 2020, which sets the framework for carbon neutrality by 2050 and includes specific actions and goals to reach by 2030. According to the PNIEC, the energy sector, including natural gas, accounts for 75% of greenhouse emissions in Spain. However, even if declining in absolute terms, natural gas will increase to 23.5% by 2030 as a share of total primary consumption from 20.8% in 2020 as that for coal and petroleum declines (see table 5), due to its relatively lower carbon footprint than those fuels. This means that, although gas consumption will remain at best stable toward 2030, the Spanish energy plan for natural gas is less stringent than for other fossil fuels.

Table 5

We believe that gas will play a relevant role in decarbonizing the industry, particularly in sectors with high-calorific processes where it is not easy to switch to electricity, such as the pharmaceutical; food and beverages; and pulp, paper, and packaging industries. In addition, gas could see new opportunities for growth in the transportation industry, where it currently accounts for less than 1% of energy. Gas will have more opportunities in heavy transportation, such as maritime freight or heavy trucks, where batteries are still not a viable solution.

We see gas operators across Europe and Spain lobbying, together with other stakeholders, to accelerate the development of "green hydrogen" infrastructure, which could be relevant after gas plays out it current role as a bridge fuel in the energy transition. In Spain, MITECO, Spain's environment ministry, recently opened a public consultation on a framework for hydrogen storage and infrastructure development that would become part of the country's energy plan, highlighting the advantages of the use of green hydrogen in electricity generation, transportation, and thermal industrial processes.

We believe that the development of hydrogen infrastructure will require cooperation among many stakeholders, mainly network operators, industrial consumers, and regulators. The development of large-scale hydrogen solutions is in the very early stages, but it is positive for the gas sector and could benefit network operators over the long term.

Why does S&P Global Ratings still assess Spanish regulatory frameworks as strong/adequate?

Our view of the Spanish regulatory regime is supported by the following:

• The Spanish electricity and gas networks benefit from stable remuneration schemes, confirmed by the CNMC in the most recent regulatory review. The tariff structure is stable and allows companies to recover their costs and earn fair returns.
• The electricity remuneration is based on the regulated asset base (RAB) and the weighted average cost of capital (WACC), while gas distribution remuneration is based on a parametric formula, allowing for market-based growth.
• Six-year regulatory periods provide predictability and transparency, with the possibility of a revision of parameters every three years for electricity transmission and distribution.
• We see the appointment of the CNMC as an independent regulator in January 2019 as positive, although we do not have yet a track record to assess the regulator's independence.
• Spain benefits from the long-term vision, targets, and directives on energy policy defined at the EU level.

Our view of the Spanish regulatory regime is weakened by the following:

• A cumulative tariff deficit of €16.6 billion for electricity as of Dec. 31, 2019, and €453 million for gas as of Dec. 31, 2019.
• A limited track record regarding revision of the six-year regulatory periods, particularly after what we viewed as a disruptive process for gas remuneration.
• The methodology for reviewing the process for a reasonable rate of return for electricity networks for the next regulatory period, which is based on a WACC calculation but that can be limited by a discretional cap set by law.
• By law, tariffs for gas and electricity transmission system operators (TSOs) and DSOs are not linked to the consumer price index.
• The sensitivity of gas distribution operators to fluctuations in gas volumes in Spain, which is limited but contrasts with the situation in other jurisdictions that has no volume exposure at all.
• Capital in progress is not being remunerated, which adds volatility to the debt metrics of companies investing in large regulated assets.

We view gas and electricity grids diverging as the role of electricity amid the Spanish Energy Plan provides substantial incentives for electrification and grid investments, which are based on RAB. We believe that investments in gas transmission will become more selective, although there is some room for saturation of the grid at the distribution level. On the other hand, the electricity system has a large deficit that we view as a key weakness, while the gas market is almost in balance.

Another important consideration for us regarding regulation is its ability to effectively and timely reduce the system's tariff deficit. The accumulated gas system deficit was about €453 million at end-2019 (see chart 2). In contrast, the electricity system deficit was close to €16.6 billion as of Dec. 31, 2019. What's more, the gas system generated a surplus in 2019, and will continue to close the gap over the next few years.

Table 6

Related Research

COVID-19

• Recent Rating Reviews On EMEA Utilities Reflect The Sector's Strength Against COVID-19 Shock, April 7, 2020
• EMEA Utilities Should Withstand COVID-19 Better Than Most Sectors, March 24, 2020

Sector

• Spain's Stricter Utility Regulations Are In Line With Our Expectations, Nov. 6, 2019
• Various Rating Actions Taken On Spanish Gas DSOs And TSOs Following Regulatory Proposal, July 25, 2019
• What Spain's Slower Phaseout Of Nuclear Energy Means For Power Producers, March 7, 2019
• The End To Subsidies: The Beginning Of A New Era For Spanish Renewables, Feb. 7, 2018
• Why We See Spain's Electricity And Gas Regulatory Frameworks As Mostly Supportive, May 11, 2017

Company-specific

• Bulletin: Spain-Based Enagas S.A.'s 2019 Results And New Strategic Plan Are In Line With Our Expectations, Feb. 18, 2020
• S&P Global Updates Its View On Spanish Gas Distribution System Operators, Feb. 17, 2020
• Bulletin: Lower Investments And Disposals Keep Naturgy's Financial Metrics Within Projections Despite Less-Than-Expected EBITDA , Feb. 5, 2020
• Iberdrola S.A., Jan. 10, 2020
• Bulletin: Enagas' Credit Quality Can Handle Upping Stake In Tallgrass Energy To About 30% Thanks To A Capital Increase, Dec. 19, 2019
• Research Update: Spanish Gas TSO Enagas Outlook Revised To Stable On Final Regulatory Determination, Despite Weakening Business Risk, Nov. 28, 2019
• Bulletin: Red Electrica Corporacion Can Absorb Argo Stake Acquisition , Nov. 28, 2019
• Enagas S.A., July 31, 2019
• Iberdrola Will Use Strong Results In First-Half 2019, Despite Weak Hydro Production, For Growth, July 25, 2019
• Viesgo Holdco S.A.U., July 19, 2019
• Red Electrica Corporacion S.A., July 16, 2019
• Research Update: NorteGas Energia Distribucion S.A.U. 'BBB-' Ratings Affirmed On €250 Million Capital Injection; Outlook Stable, June 4, 2019
• Naturgy Energy Group S.A., April 23, 2019