Table 1

Table 2

Operator Profiles

In Italy (BBB/Stable/A-2), the electricity and gas regulator is Autorità di Regolazione per Energia, Reti e Ambiente (ARERA). Key operators include Terna SpA, Enel SpA, Acea SpA, A2A SpA, Iren SpA, SNAM SpA, Italgas, 2i Rete Gas, and Hera SpA (see table 3).

Table 3

Assessment Factors

Regulatory stability: Solid track record of predictable frameworks helps offset country risk

Both the electricity and gas systems are based on clear regulations, with a solid track record of predictable revenue and returns over the past 20 years, and governed by ARERA, which acts as an independent regulator. The relative insulation of the regulatory remuneration from Italy's economic and political situation proves supportive, and reinforces our view of the stability of the regulation.

We see the stability of Italy's electricity regulation as supported by relatively long, but flexible regulatory periods and a solid track record of predictability.   In 2016, ARERA extended the regulatory period to eight years from four. The period consists of two four-year subperiods called new regulatory period 1 and 2. A review of the parameters related to operating costs takes place between subperiods. At the end of the fifth and current period, the regulator aims to progressively shift toward a forward-looking regulation, including both a total-expenditure remuneration model like in the U.K., and output-based regulation. This would allow more flexibility on investment allocation. We view these developments, if and when implemented, as likely positive for our assessment of the regulatory framework.

The current weighted average cost of capital (WACC) period started in 2016 and lasts six years, and consists of two subperiods (2016-2018 and 2019-2021). At the end of the first subperiod, ARERA reviewed and adjusted parameters to market conditions and to ensure companies' financial stability. ARERA updated the country risk premium, inflation, gearing, and the tax rate (all components of the WACC formula) for the following subperiod.

We see Italy's gas regulation as advanced, and having a solid track record of predictability.   As with electricity, we understand ARERA plans to introduce efficiency incentives on the capital costs of gas distribution services (from 2023 at the earliest), but we believe the impact of such incentives will be marginal in the remuneration formula in 2023-2025. The gas tariff regulation is organized under periods and subperiods, allowing for a mid-period review of some parameters, like the asset beta used in the capital asset pricing model formula to determine the WACC. The next regulatory period starts in 2024 for gas transmission and 2026 for gas distribution, and we currently expect the remuneration formula to remain broadly in line with the current one, with the addition of efficiency incentives on capital expenditure (capex). This is notably supported by the important role of gas in the energy mix (we expect it will remain at about 45% by 2024).

Chart 1

Tariff setting: A detailed and transparent process

The Italian regulator interacts in an open and transparent way with regulated players.  This takes place through the publication of several consultation papers well ahead of the scheduled regulatory revision. This allows key actors to actively manage regulatory risk and better anticipate reset risks. Normally, each consultation period must last at least 30 days, but the process can be much longer. For example, for the current gas distribution regulatory period, in place since January 2020, ARERA published its first consultation paper in May 2019, followed by two others in July and October. Finally, the regulation bill comes with a statement detailing the motivation behind the regulatory decisions and is often accompanied by a technical report. All of ARERA's decisions can be appealed through ordinary administrative jurisdiction. For instance, ARERA's last decision on the gas distribution remuneration scheme, published in December 2019, is currently being appealed by some gas utilities that challenge the recognized operating costs and the beta coefficient used for the WACC calculation. We are not aware of any major court ruling against ARERA's remuneration schemes.

Chart 2

The Italian framework displays relatively high WACC levels compared with other jurisdictions.  The WACC level remains high both in absolute terms and compared to that of European peers, with a retained cost of equity that is higher than the ones set recently in Spain, France, and the U.K. (see table 4). The higher WACC levels can be explained by the higher country risk premium. The regulator may lower the WACC to reflect the lower cost of debt, however we believe ARERA will be mindful of a gradual decline in the cost of equity, given the large investments needed to continue electrifying and decarbonizing the country.

Table 4

Incentives to foster efficiency do not materially alter cash flow visibility.  In addition to the tariff, the regulator sets regulatory incentive mechanisms (on controllable costs) to encourage operators to improve performance. These financial mechanisms result in bonuses or penalties, depending on whether operators meet objectives, resulting in a symmetrical treatment. These incentives are manageable and capped. For Terna, the maximum amount is €7 million, and on top of this, another mechanism based on output-based incentives is in place and could grant total extra remuneration of up to €300 million for the period ending in 2023. Efficiency factors within tariffs have been mostly achievable for operators (0.4% for Terna; and 1.3% for power DSOs), facilitated by low inflation. In the gas sector, the regulator included an efficiency factor in the remuneration formula to encourage sector consolidation and incentivize efficiency to ultimately reduce consumers' tariffs-–but with little success so far.

Chart 3

Financial stability: Strong, based on full and timely cost recovery, despite significant investments ahead

We assess the Italian electricity and gas operators' earnings volatility throughout regulatory periods as low. Our assessment of financial stability stems from resilience of the regulated sector's earnings to periods of stress, such as the 2007-2008 financial crisis and Italy's sovereign debt crisis, and the ongoing COVID-19 pandemic. During these periods, companies remained relatively insulated from the stress and energy regulation remained supportive and unchanged in the country. This demonstrates network operators' ability to maintain superior stand-alone creditworthiness to the sovereign, and operators' undisrupted access to funding allowed them to execute their capex plans.

We believe this earnings stability is partly explained by the relative wealth of the Italian population considering GDP per capita and the decorrelation between Italy's public and private debt (households plus corporates), which are the lowest among the G-7 countries. As a result, we believe pressure from energy bills remains manageable for the system in comparison to other 'BBB'-rated sovereigns.

The framework has a track record of no tariff deficits.  The regulation provides tariff systems that cover the costs operators incur and allows for a fair return on invested capital. Electricity and gas transmission and distribution have a similar remuneration model structured on costs incurred and incentives. Allowed revenue incorporates allowed operating costs, allowed regulatory asset base (RAB) depreciation, and allowed profits (through the remunerated RAB at the WACC rate of return). The allowed value of revenue is based on the average number of customers and guaranteed by an equalization mechanism, with 100% of revenue shielded from volume risk. Furthermore, the framework provides full protection against inflation. RAB is calculated at revalued historical cost, therefore considering investments using an annual deflator. This allows the regulator and the players to consider RAB at constant prices, taking out the effect of inflation. Revenue is also inflation-linked.

Operators receive fair remuneration for works in progress (WIP).  We expect a significant ramp-up of investments will accelerate the electrification of Italian economy, as included in the national energy plan (Piano Nazionale Integrato per l'Energia e il Clima), published in January 2020. ARERA takes operators' capitalized investments into account in determining remuneration, so that growth in remuneration is directly linked to capital invested. This protects regulated entities' earnings and is particularly supportive in a period of accelerated investments. For ongoing capitalized investments (realized since 2016 but not yet completed in the year prior to the new regulatory period) in the electricity transmission market (WIP), ARERA allows for remuneration for the first four years of the project's capitalization, with rates decreasing after the first two years. For gas transmission, WIP are included in the RAB and remunerated at 5.3% in real pre-tax terms with no time limit on compensation. For regasification, WIP is excluded from the RAB calculation from 2020 but compensated by the allowance of the interest expense related to the investments into operation. For storage, WIP are excluded from RAB.

Regulator's independence: Strong and supportive track record of independence from any other public or private interests

The Italian Ministry of Economic Development defines the energy sector's strategy and sets out general principles for the organization and functioning of the electricity and gas markets (for example, new capacity generation, energy efficiency measures, and security of supply). ARERA, as the energy regulator, sets allowed revenues and tariffs used to remunerate the access and operations of the infrastructure and controls the quality of services.

ARERA's governing body consists of a president and four members, which are nominated by Italy's president based on proposals made by the relevant ministries that are subject to parliamentary oversight. All parties of the governing body are experts in power, gas, and water regulation, and remain in charge for seven years without the possibility of a double tenure.

While we recognize that the selection process of ARERA's governing body is somewhat politicized, its track record over recent years supports our view of the body's strong independence from political interests. Despite the instability of the political landscape, ARERA has been able to perform its tasks in a timely and transparent manner.

While not part of the regulatory remuneration framework, we note Italy's unfavorable episode of political interference: in 2008, the Italian government introduced a tax levied on Italian energy companies applied from 2011. Though this had the potential to dent otherwise-predictable earnings of regulated entities, the Italian constitutional court ruled the tax unconstitutional in 2015.