Scotland Gas Networks plc - SGN

INFRASTRUCTURE AND PROJECT FINANCE

CREDIT OPINION12 May 2021

Update

RATINGS

Scotland Gas Networks plcDomicile United Kingdom

Long Term Rating Baa1

Type LT Issuer Rating - DomCurr

Outlook Negative

Please see the ratings section at the end of this reportfor more information. The ratings and outlook shownreflect information as of the publication date.

Contacts

Philip Cope [email protected]

Muhammad Usman +44.20.7772.5691Associate [email protected]

Paul Marty +33.1.5330.3371Senior Vice President/[email protected]

Neil Griffiths-Lambeth

+44.20.7772.5543

Associate Managing [email protected]

Scotland Gas Networks plcUpdate following rating affirmation with negative outlookmaintained

SummaryThe credit quality of Scotland Gas Networks plc (Scotland GN, Baa1 negative) benefits from(1) the company's position as the monopoly owner and operator of the gas distributionnetwork in the south of England, (2) its low business risk, and (3) the sector's well-establishedand transparent regulatory regime.

Credit quality is constrained by the company's high leverage relative to peers and regulatoryassumptions with net debt to regulatory asset value (RAV) typically above 70%. Strongoperational performance during the previous RIIO-GD1 regulatory period supported interestcover metrics. However, in the current regulatory period (RIIO-GD2, which began on 1 April2021), allowed returns are lower, due to the large cuts in allowed equity returns, and thescope for operational outperformance is limited.

The negative outlook reflects that absent an increase in regulatory allowances from thepending appeal of aspects of its RIIO-GD2 regulatory determination or measures to protectcredit quality, we expect Scotland GN to maintain an average adjusted interest coverageratio (AICR) during RIIO-GD2 of c. 1.35x (excluding timing differences which will materiallysupport metrics in financial year ending March 2023), slightly below our minimum guidancefor the Baa1 rating level of 1.4x.

Exhibit 1

Absent an increase in regulatory allowances from a successful appeal or measures to protectcredit quality, Scotland GN will fall short of minimum interest coverage guidance in RIIO-GD2Breakdown of Moody's projected AICR with no operational outperformance of regulatory settlement

-0.2x

0.0x

0.2x

0.4x

0.6x

0.8x

1.0x

1.2x

1.4x

1.6x

FY2022 FY2023 FY2024 FY2025 FY2026

Minimum Baa1 guidance (≥1.4x)

Base Return (regulatory return / interest expense) Equity issuance allowance (FY2022 only)

Totex Performance & Mix Sharing of Performance & Legacy

Incentive Payments (earnt in RIIO-GD1) AICR before timing differences

Source: Moody's Investors Service

http://www.surveygizmo.com/s3/1133212/Rate-this-research?pubid=PBC_1282389

https://www.moodys.com/credit-ratings/Scotland-Gas-Networks-plc-credit-rating-808742628

MOODY'S INVESTORS SERVICE INFRASTRUCTURE AND PROJECT FINANCE

Credit strengths

» Well-established and transparent regulatory framework, underpinning stable and predictable cash flows with visibility until 2026

» Track record of strong operational performance, particularly against regulatory cost allowances. Operating cash flows in FY2022 andFY2023 will continue to benefit from incentive income earnt in RIIO-GD1 as the rewards are paid with a two year lag

Credit challenges

» Interest coverage metrics are depressed by higher leverage, as measured by net debt to regulatory asset value (RAV), than otherenergy networks and regulatory assumptions

» Interest coverage metrics will likely weaken in RIIO-GD2 given lower allowed returns and challenging regulatory efficiency targetsand allowances

» Additional leverage at Scotland GN's parent company, SGN MidCo Limited (SGN MidCo)

Rating outlookOn 23 April we affirmed Scotland GN's ratings and maintained the negative outlook. The negative outlook reflects our expectation thatScotland GN will exhibit financial metrics, excluding timing differences, over the RIIO-GD2 period slightly below levels commensuratewith the Baa1 rating level if it performs in line with regulatory determination, as it currently stands, absent measures to bolster creditquality. The Competition and Markets Authority, CMA, is hearing the appeal of aspects of Scotland GN's determination and will makeits decision by 30 October.

Factors that could lead to an upgrade

» Given the negative outlook, we currently see little potential for upward pressure on the ratings

» The outlook could be stabilised if it appeared likely that the CMA's determination would support interest coverage metricsconsistent with the assigned rating (at least 1.4x).

» The outlook could also change to stable if Scotland GN appeared likely to deliver modest operational outperformance in RIIO-GD2or the SGN group took measures to strengthen its balance sheet and/or materially reduce financing costs

Factors that could lead to a downgrade

» If the CMA rejected SGN's appeals and we considered (1) Scotland GN was unlikely to deliver modest levels of operationaloutperformance in RIIO-GD2; and (2) SGN was unlikely or take measures to protect Scotland GN's credit quality

» The ratings could also be downgraded if (1) Scotland GN's net debt to RAV rose above 75%; or (2) a more aggressive financial policywas pursued at the companies' immediate parent company, SGN MidCo Limited (SGN MidCo), such that either net debt to RAVrose above 85% or AICR fell below 1.2x. We do not anticipate this situation arising

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 12 May 2021 Scotland Gas Networks plc: Update following rating affirmation with negative outlook maintained

https://www.moodys.com/research/Moodys-affirms-Baa1-ratings-of-Scotland-Gas-Networks-and-Southern--PR_444864


Key indicators

Exhibit 2

Scotland Gas Networks plcTiming differences impact reported metrics (materially depressing metrics in FY2018 and FY2019 but supporting them in FY2023) Mar-18 Mar-19 Mar-20 2021-proj. 2022-proj 2023-proj 2024-proj

Adjusted Interest Coverage Ratio 1.9x 1.6x 1.6x 2.0x 1.4x 1.7x 1.4x

Net Debt / RAV 72.4% 72.6% 74.2% 71.9% 73.1% 73.1% 73.2%

FFO / Net Debt 11.5% 11.6% 11.4% 13.1% 8.6% 9.7% 9.2%

RCF / Net Debt 6.0% 9.2% 9.3% 13.1% 6.4% 7.6% 7.0%

All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. Moody's Projections (proj.) are Moody's opinion anddo not represent the views of the issuer.Scotland's net debt / RAV in March 2019 and March 2020 is around 71% if intercompany loan receivables, from the group's main subsidiary (Southern Gas Networks plc - Baa1 negative,another gas distribution network in Great Britain) are excluded.Source: Moody's Financial Metrics™

ProfileScotland GN is the second smallest of the eight gas distribution networks (GDNs) in Great Britain by RAV, £1.8 billion at March 2021. Itprovides gas distribution services to around 1.8 million customers through around 25,000 kilometres of gas pipelines in Scotland.

Exhibit 3

Regulated Asset Value by gas distribution network operator groupRegulatory RAV at 31 March 2021, nominal

49%

11%

29%

11% East of England, £3.4bn

London, £2.6bn

North West, £2.4bn

West Midlands, £1.8bn

Northern, £2.3bn

Scotland, £1.8bn

Southern, £4.1bn

Wales & West, £2.3bn

Cadent, £10.2bnSGN, £6.0bn

Note: Opening regulatory RAV for RIIO-GD2 as published in Ofgem's revised final determination of 3 February 2021.Source: Ofgem, Moody's Investors Service

Scotland GN is a wholly owned subsidiary of Scotia Gas Networks Limited (SGN HoldCo) via the intermediate holding companiesSGN MidCo Limited (SGN MidCo) and SGN PledgeCo Limited. SGN HoldCo is, in turn, owned by a consortium including SSE plc (Baa1negative), OMERS Administration Corporation (Aa1 negative), Ontario Teachers’ Pension Plan Board (Aa1 stable) and the Abu DhabiInvestment Authority.

SGN also owns another gas distribution network in Great Britain, Southern Gas Networks plc (Southern GN, Baa1 negative). The twonetworks are operationally managed as one entity, although as they have separate regulatory licenses they remain legally separateand independent of each other and their respective performances are judged on a standalone basis. SGN, through SGN CommercialServices Ltd, completed the construction and commissioning of the Gas to the West project in Northern Ireland. This has beentransferred to Mutual Energy to own and operate. The majority of costs were recovered in March 2021 and an established regulatoryprocess governs recovery of the remaining amount. SGN Natural Gas has the licence to operate the low pressure network thatdistributes gas across the west of Northern Ireland; the network is currently being established.


https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1106999

https://www.moodys.com/credit-ratings/SSE-plc-credit-rating-18030

https://www.moodys.com/credit-ratings/OMERS-Administration-Corporation-credit-rating-824869406/summary

https://www.moodys.com/credit-ratings/Ontario-Teachers-Pension-Plan-Board-credit-rating-809848977

https://www.moodys.com/credit-ratings/Southern-Gas-Networks-plc-credit-rating-808742629


Detailed credit considerationsWell-established and transparent regulatory framework underpins stable and predictable cash flow; good visibility untilMarch 2026The GDNs in Great Britain benefit from a very transparent, stable and predictable regulatory regime based on clearly defined riskand reward principles. It is overseen by an experienced regulator, the Office of Gas and Electricity Markets (Ofgem), with a long trackrecord of consistent decision making. Ofgem has consulted widely with a variety of stakeholders whenever changes to the regulatoryframework have been made in the past. Scotland GN has significant visibility in relation to future cash flow under the current pricecontrol for gas distribution (RIIO-GD1), which began on 1 April 2021 and runs until 31 March 2026, although some aspects of thedetermination are pending appeal (discussed below).

Exhibit 4

Scotland GN service areaExhibit 5

Price control overview

Source: Energy Networks Association

GB Gas Distribution

Regulator/ Price Control Ofgem / RIIO-GD2

Regulated Business Scotland Gas Networks plc

Term of price control April 2021 - March 2026

Allowed return on RAV

(vanilla real, CPIH stripped)

2.97% (2021-22)

c. 2.85% average for RIIO-GD2

Return on regulatory equity - operational c. 4.3% allowed equity return

(c. 11.7% achieved in RIIO-GD1)

Regulated Asset Value (March 2021) £1.84 billion

(1) In RIIO-GD2, average allowed return and allowed return on regulatory equity (RoRE)are estimates as per Ofgem's revised final determination; (2) Estimates of operationalRoRE in RIIO-GD1 from Scotland GN's Regulatory Financial Performance Reporting (RFRP)2019-20. 6.7% (real, RPI stripped) was the regulatory assumption; (3) RAV is opening RAVfor RIIO-GD2 as per Ofgem's revised final determination.Source: Ofgem

We continue to see regulation of the UK energy networks by Ofgem as among the most transparent regimes and on a par with ‘bestin class’ globally. Social risks have, however, become evident, with the regulator diverging at the margin from established practicefollowing criticism (see RIIO-2 proposals support sector’s business risk profile, but legitimacy in greater focus, 3 August 2020 for moredetails).

RIIO-GD2 regulatory determination is challengingDespite concessions between Ofgem's draft and final decisions for transmission and gas distribution controls (see Ofgem gives groundat final ruling but credit quality will still weaken in RIIO-2, 9 December 2020 for more information), the RIIO-2 final determinationis materially tougher than the regulatory settlement for RIIO-1 in all key areas (allowed equity returns, regulatory cost allowances -both the regulatory benchmark used to assess cost efficiency and assumed annual productivity gains, and output delivery incentivescarrying financial rewards or penalties). This is illustrated in the exhibit below, where moves towards the centre result in a reduction ofoperational cash flows. The incentive package is also weaker than in the prior regulatory period, particularly on performance againstcost allowances, with both fewer rewards, and reduced scope to earn these, for the top performing networks.


e%20RIIO-2%20proposals%20support%20sector%e2%80%99s%20business%20risk%20profile,%20but%20legitimacy%20in%20greater%20focus




Exhibit 6

Regulatory allowances and targets are materially tougher in RIIO-GD2 than RIIO-GD1The closer to the centre the more challenging the regulatory allowance/target, which in turn depresses operational cash flows

Source: Regulatory data; Moody's Investors Service

Materially lower allowed equity returns from 1 April 2021 will depress operating cash flows ...Scotland GN's allowed equity returns are expected to be around 35% lower, on a cash basis (c. 45% on a comparable basis1.), inRIIO-GD2 than RIIO-GD1. As shown below, the main driver of this change is the reduction in the expected cost of equity, reflectingboth methodology changes between the control periods by Ofgem and the sustained low yield environment, with the 25 basis pointdownward adjustment for assumed outperformance (the outperformance wedge, which also reduces the stability and predictability ofthe regulatory regime) also contributing.

Exhibit 7

Allowed equity returns are materially lower in RIIO-GD2 in RIIO-GD1Bridge between allowed equity returns in RIIO-GD1 and RIIO-GD2

6.7

1

-3.15

-0.25

4.3

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Allowed equity return(RIIO-GD1)

Move to lower inflation measure forRIIO-2

Change in expected cost of equity(CAPM)

Assumed outperformance Allowed equity return(RIIO-GD2 avg.)

%UK water: Ofwat determination for current price control (PR19) - 4.19% UK water: CMA's final decision for UK water appellants in PR19 - 4.73%

Allowed equity return for RIIO-GD2 is based off Ofgem's published estimate in its revised final determination, published 3 February 2021Source: Regulatory data; Moody's Investors



Under the final determination, the cut in allowed equity returns reduces Scotland GN's operational cash flows by nearly £20 millionper annum in RIIO-GD2, equivalent to over 40% of the company's FY2020 interest expense. The overall reduction in regulatory return(RAV * allowed return) is smaller, around £4 million per annum, due to (1) the lower regulatory gearing assumption for RIIO-GD2 thanRIIO-GD1 (60% compared to 65%); and (2) the higher regulatory cost of debt allowance in RIIO-GD2 than RIIO-GD1 (largely due tothe move to a structurally lower measure of inflation, CPIH rather than RPI).

Exhibit 8

Scotland GN's cash allowed returns fell slightly between RIIO-GD1 and RIIO-GD2 and we expect will fall gradually thereafterEvolution of allowed returns over RIIO-GD1 and RIIO-GD2 (April 2022 onwards an estimate)

4.24 4.11

4.00 3.89

3.79 3.59

3.37

3.05 2.972.87 2.81 2.79 2.82

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Apr 13 Apr 14 Apr 15 Apr 16 Apr 17 Apr 18 Apr 19 Apr 20 Apr 21 Apr 22 Apr 23 Apr 24 Apr 25 Apr 26

%

Vanilla WACC (RPI-stripped) Vanilla WACC (Moody's forecast, CPI-stripped) Vanilla WACC (Ofgem's FD forecast, CPI-stripped)

RIIO-GD1 RIIO-GD2

Source: Ofgem; Moody's Investors Service

… impact accentuated by comparatively high leverage and low levels of index linked debtScotland GN enters RIIO-GD2 with a lower base return (regulatory return divided by interest expense) than most sector peers dueits comparatively higher interest expense stemming from (1) slightly higher leverage; and (2) higher embedded cash interest costs,particularly compared to Cadent Gas Limited (Baa1 stable). As Exhibit 1 shows, with the cut in regulatory return in RIIO-GD2, we expectScotland GN to maintain a base return slightly below 1.4x (on average over the period), the minimum guidance for the Baa1 rating,unless there is an increase in regulatory allowed returns following a redetermination or SGN acts to protect credit quality.

Exhibit 9

SGN GDN's have the highest leverage in the sectorMoody's adjusted net debt / RAV at March 2020

Exhibit 10

Scotland GN's cash cost of debt allowance will fall over RIIO-GD2but remain higher than in FY2021Evolution of Scotland GN's regulatory cost of debt allowance (Moody'sprojections in RIIO-GD2)

50%

55%

60%

65%

70%

75%

Scotland Southern Cadent Northern RIIO-GD1 RIIO-GD2

GN GN Gas Gas Ofgem assumption

Scotland GN's leverage is around 71% if intercompany loan receivables from Southern GNare excluded.Source: Moody's Investors Service

2.922.72

2.552.38

2.221.91

1.58

1.09

2.111.94 1.79 1.69 1.64

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

13 14 15 16 17 18 19 20 21 22 23 24 25 26

%

Regulatory year commencing April

20

iBoxx non-financials A/BBB 10+yrs spot yield (real, breakeven RPI-stripped)iBoxx Utilities 10+yrs spot yield (real, OBR 5yr forecast CPI-stripped)Cost of debt allowance (10 year average, breakeven RPI-stripped)Cost of debt allowance (10-14 year average, OBR forecast 5yr CPI-stripped)

RIIO-GD1 RIIO-GD2

Ofgem used a trailing average of the iBoxx non-financial (average of A and BBB series) andiBoxx utilities series (plus an additional costs of borrowing allowance, 31 bps for ScotlandGN) to set the cost of debt allowance in RIIO-1 and RIIO-2 respectively.Source: Regulatory data; Moody's Investors Service


https://www.moodys.com/credit-ratings/Cadent-Gas-Limited-credit-rating-825094229/summary


Limited scope for operational outperformance due to challenging regulatory cost allowancesScotland GN has a track record of excellent operating performance, evidenced by it outperforming cost allowances by around 18% inRIIO-GD1, primarily due to its performance on operating expenditure (both direct and indirect) and replacement expenditure (repex).The sharing of some of these costs savings with customers acts as a slight drag on AICR in the first two years of RIIO-GD2, see Exhibit 1.

We expect that Scotland GN will perform broadly in line with regulatory cost allowances over RIIO-GD2 because regulatory allowancesassume ongoing annual productivity gains averaging 1.2%, significantly above the levels in prior regulatory determinations for UKregulated utilities (below 1% in RIIO-1 distribution controls) and Scotland GN's regulatory submission. This higher level of ongoingefficiency assumptions accounted for 30% (after considering volume adjustments, £17 million in 2018-19 prices) of Ofgem's cut inScotland GN's requested cost allowances with the majority (55%) attributable to technical adjustments. Whilst Scotland GN came 5thin Ofgem's benchmark analysis, we note that it is one of the few GDNs with annual totex allowances c. 4% higher than its expenditurein RIIO-12 (£188 million compared to £181 million, both in 2018-19 prices), primarily due to c. 9% higher non-repex allowances. Thisreduces the likelihood of underperformance against regulatory cost allowances in our view.

Exhibit 11

Scotland GN had a slightly smaller cut in baseline cost allowances than the sector average

7.5%

12.5%

5.2%

14.1%

6.4%

7.4%

5.1%

3.8%

8.2%

5.8%

11.3%

6.4%

14.3%

6.2%

7.7%

2.3% 2.5%

6.8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Scotland GN

5

Scotia Gas

Southern GN

7

Scotia Gas

East of England

4

Cadent Gas

London

8

Cadent Gas

North West

3

Cadent Gas

West Midlands

6

Cadent Gas

Northern Gas

1

Northern Gas Networks

Wales & West

2

Wales & West

Sector

Position in Ofgembenchmark

Owner

GDN

Headline FD cut in baseline allowances vs revised regulatory submission Comparable cut (post transfers for volume adjustments and uncertainty mechanisms)

Data from revised final determination of 3 February 2021 and final GDN regulatory submission as of September 2020.Source: Regulatory data and Moody's Investors Service

In RIIO-GD1, Scotland GN earnt around £3.6 million per annum (in 2019/20 prices, around 2.3% of Funds From Operations overthe last three financial years) from output delivery incentives carrying financial rewards or penalties (ODI-Fs). Around 70% of thiscame from the broad measure of customer satisfaction where the company was consistently the top ranked network. However, earntincentive income on shrinkage and environmental emissions (together slightly below £1 million per annum) was well below peers andso the boost to Scotland GN's operating cash flows in FY2022 and FY2023 from total incentive income earnt in RIIO-GD1, rewards arepaid with a two-year lag, is limited (as Exhibit 1 shows). With significantly more demanding regulatory targets and different calibrationof ODI-Fs with reduced reward opportunities in RIIO-GD2 than in RIIO-GD1, particularly on the customer satisfaction survey andshrinkage incentive, we expect earnt incentive income from ODI-Fs to be lower in RIIO-GD2.

Modest upside potential from pending appeals; precedent set for future regulatory periods just as importantLike all the incumbent gas distribution and transmission networks, SGN (who filed the appeal on behalf of Scotland GN and SouthernGN) has lodged several technical appeals on aspects of its regulatory determination where it believes the regulator has made a clearand material error (see highlight box below for more information). The Competition and Markets Authority (CMA) agreed on 31March to review all the points SGN sought permission to appeal and will make its final decision by 30 October. Since other aspectsof the regulatory determination cannot be revisited as part of the CMA's review, and based on the CMA's final decision for the fourUK water companies that successfully appealed aspects of their recent regulatory determination, we see negligible downside risk andpotentially modest upside for RIIO-GD2. There may also be greater benefit in future regulatory periods due to the precedent set, e.g. ifthe CMA overturn the downward adjustment to allowed equity returns for assumed outperformance and the use of a more challengingefficiency benchmark (the proximity of the second and third ranked GDNs meant the impact on regulatory allowances of the tougher



benchmark was limited). A reduction in the size of the cut in allowed equity returns would increase base returns while higher regulatorycost allowances would increase the scope for modest operational outperformance.

Pending appeals source of modest upside

All nine transmission and gas distribution licence holders sought permission on 3 March 2021 to appeal the regulator's decision of 3 February2021 on the proposed modification to their licenses required to enact Ofgem's revised final determination for the RIIO-2 price controls.

SGN's notice of appeal3, filed on behalf of Scotland GN and Southern GN, cited four key areas where the company believe the regulator is“wrong”: (1) cost of equity; (2) outperformance wedge; and (3) ongoing efficiency; and (4) the level of the efficient cost benchmark used tocalculate modelled cost allowances.

On 31 March, the CMA granted permission to appeal on all grounds pleaded by the appellants with common grounds of appeal joined acrossappellants (all appellants challenged technical aspects of the cost of equity calculation and the outperformance wedge; and all gas distributionlicensees challenged Ofgem's ongoing efficiency assumptions, though they proposed different levels). The CMA will make its final decision by30 October (it decided in April to utilise the one month extension to the statutory deadline) with its provisional determination scheduled forearly August.

The energy network appeals follow shortly after the successful CMA appeals by four UK water companies of Ofwat's PR19 regulatorydetermination, see CMA final decision is credit positive for appellants, 18 March, for more information. Most of SGN's appeal grounds havesome degree of overlap with the CMA's final decision on PR19.

Our projections (see Exhibit 1) do not assume any upside from the appeals, but we consider that some upside is likely. Scotland GN's revenuesover RIIO-GD2 would rise by c. £16 million (2018-19 prices), c. 1.8% of current regulatory totex allowances, if the (1) outperformance wedgewas overturned (£8.9 million), adding c. 0.04x to AICR metrics; (2) base ongoing efficiency was lowered to 1% from 1.2% (£7.3 million), eitherthrough the removal of additional innovation challenge or using the PR19 value. Incremental upside, beyond these two areas, of at least £18million, would be contingent on the CMA enacting changes to Ofgem's cost of equity methodology as per its decision on PR19 appeal, seeExhibit 7, but without a downwards beta adjustment.

ESG considerationsLong-term decline in gas demandAlthough Scotland GN continues to make significant investments in the network to maintain reliability and safety, underlying averagegas demand is falling sharply. Gas consumption in Great Britain fell 14% between 2010 and 2019 to 786 terawatt hours (TWh)equivalent from 916 TWh equivalent.

National Grid Electricity System Operator Limited's (Baa1 stable) latest Future Energy Scenarios forecasts that average gas demandwill decline in all scenarios considered. Gas demand remains highest in the 'Steady Progression' scenario, where total energy demandremains high and gas continues to be used for heating and power generation. The 'System Transformation' scenario sees gas demandfall to around 600 TWh/year, but with large quantities of gas used for hydrogen production through Steam Methane Reforming from2030 onwards.

Network investment requirements are driven by peak demand4 rather than average demand. The 'Steady Progression' scenario seesessentially no reduction in peak demand from today's levels, whereas peak demand could decline by a third by 2030 under 'ConsumerTransformation' or 'Leading the Way'.



https://www.moodys.com/credit-ratings/National-Grid-Electricity-System-Operator-Ltd-credit-rating-830661156

https://www.nationalgrideso.com/document/173821/download


Exhibit 12

Gas demand is likely to decline further inall scenariosFuture Energy Scenarios 2020

Exhibit 13

Under the System Transformationscenario, the majority of gas demand willtransition to hydrogen by 2050Future Energy Scenarios 2020

Exhibit 14

Domestic heating is expected to transitionaway from gasFuture Energy Scenarios 2020

0

200

400

600

800

1,000

2010 2020 2030 2040 2050

TW

h/y

ea

r

HistoricalConsumer TransformationSystem TransformationSteady ProgressionLeading the Way

Annual gas demand per calendar year, excluding shrinkageand exports.Source: National Grid Electricity System Operator

0

100

200

300

400

500

600

700

800

900

1,000

2010 2020 2030 2040 2050

TW

h/y

ea

r

Residential Industry & commercialPower generation TransportHydrogen production

This scenario assumes homes and businesses transition tohydrogen and electric technologies for heat.Source: National Grid Electricity System Operator

0

5

10

15

20

25

30

2019 2024 2029 2034 2039 2044 2049

Nu

mb

er

of d

om

estic g

as b

oile

rs (

millio

ns)

Consumer TransformationSystem TransformationSteady ProgressionLeading the Way

Source: National Grid Electricity System Operator

Over the last two years, the UK has set ambitious decarbonisation objectives. In June 2019 the UK passed legislation committing tonet zero greenhouse gas emissions by 2050,5 and in April 2021 set in law the Climate Change Committee's recommendation of a 78%emissions reduction (from 1990 levels) by 2035. The net zero target means that any emissions will need to be balanced by schemes tooffset an equivalent amount of greenhouse gases from the atmosphere, such as planting trees or using technology like carbon captureand storage.

Both the government and the system operator have said achieving these targets will require significant technological and policychanges in the energy sector, with the role of natural gas changing on a fundamental basis (e.g. decarbonising heat and the networkbe used to accommodate hydrogen or other fuels). Over the last six months, emerging government policy has supported the furtherdevelopment of both electricification and hydrogen technology mixes.

In the short term, Scotland GN has essentially no volume exposure, as any revenue shortfalls due to faster-than-expected declines indemand can be recovered from customers with a two-year lag. In the longer term, Ofgem has a statutory obligation to “secure” thatgas transportation companies “are able to finance the provision of gas supply services.” However, a continued decline in demand forScotland GN's core service may create challenges for the business which are difficult to quantify and forecast.

Hydrogen offers possible future for networkSGN, along with the other GDN groups, are undertaking studies on the ability of gas distribution network to transport hydrogen.These studies, in totality, seek to address the relevant questions, e.g. blending of hydrogen into the network as well as heating. SGN'sflagship study is the H100 Fife (on the east coast of Scotland) project that will bring 100% renewable hydrogen into homes in 2022and received £28 million of Ofgem funding in RIIO-GD2. In the project's first phase, the network will heat around 300 local homesusing clean gas produced by a dedicated electrolysis plant, powered by a nearby offshore wind turbine. The UK government's strategy isfor 5GW of hydrogen production capacity by 2030. In April 2021, SGN set out its environmental strategy for all its business operationsto have a net zero climate impact by 2045.6

While such a fundamental change to Scotland GN's business would carry significant risks, we regard the company's effort to plan forfuture scenarios as credit positive. The RIIO-GD2 determination encompasses a material step up in allowances to facilitate the energytransition. The sector was awarded £93 million in innovation allowances (SGN received £35.6 million, the highest of any GDN group,



split between energy system transition and consumer vulnerability) and access to a strategic innovation fund of £450 million. All theGDNs received a net zero allowance (for early design work on net zero related projects on a use it or lose it basis, £10.8 million forSGN's networks). The RIIO-GD2 framework includes a net zero and heat policy reopener for wider policy decisions and large scaleprojects (there is a separate reopener for net zero pre-construction and small projects re-opener).

Social: Low exposure to covid-19Scotland GN, like other European energy networks, has low exposure to the impact of covid-19. Under the regulatory framework, anydeviations between Scotland GN's collected and allowed revenues due to throughput volumes being higher or lower than expectedare adjusted, in full, with a two-year lag. Whilst transportation volumes will be lower in FY2021 than in FY2020 due to the fall inenergy consumption, less than 5% of the GDN's revenues are sensitive to throughput volumes and so this will drive a very small under-recovery in FY2021 - in the low single digit million (less than 1% of collected revenues) we estimate.

Liquidity analysisWe view Scotland GN's liquidity as good, reflecting the (1) stable and predictable cash flow generated by its regulated gas distributionbusiness that allows it to fund the bulk of its capex and repex requirements; and (2) its access to a £360 million revolving credit facility,which it shares with Southern GN, not maturing until March 2025 and being fully undrawn as of March 2021. We assess refinancing riskas low with the company having c. £305 million of debt maturities over RIIO-GD2.

Exhibit 15

External debt maturity profile by regulatory periodAs of March 2021

0

50

100

150

200

250

300

350

FY22 FY23 FY24 FY25 FY26 FY27 FY28 FY29 FY30 FY31 FY32 FY33 FY34 FY35 FY36 FY37 FY38 FY39 FY40 FY41 FY42 FY43

RIIO-GD2 RIIO-GD3 RIIO-GD4 RIIO-GD5 RIIO-GD5

£ million EIB loans USPP notes Fixed rate bonds Index linked debt (estimated maturity value) Average per regulatory period

(1) Assumes subsequent regulatory periods are five years. (2) Maturity values for index-linked notes are estimates using the assumption of annual rate of retail price inflation of 3% untilmaturity.Source: Company; Moody's Investors Service

Structural considerationsOur assessment of Scotland GN factors in the weaker credit quality of the SGN MidCo group that it belongs to. The weaker creditprofile of the SGN MidCo group is primarily the result of the additional leverage at SGN MidCo Limited, which now comprises onlylong-term debt (c. £0.43 billion at March 2021, slightly over 7% of RAV) following repayment and cancellation of the bank facility atSGN MidCo Ltd. We expect consolidated leverage to be at or slightly below 80% over RIIO-GD2 (well below the trigger event in SGNMidCo's financing structure of 85%), a level commensurate with a mid Baa2 rating, with gearing at Scotland GN and Southern GNslightly above 70% over the same period. Due to the modest associated interest expense on this holding company debt (£10 million,or 6% of SGN MidCo group's interest expense in FY2020), and the slightly weaker interest coverage metrics at Southern GN thanScotland GN, we expect the consolidated SGN group to exhibit weaker AICR metrics (excluding timing differences) over RIIO-GD2than Scotland GN.

Although the weaker credit quality of SGN MidCo group would normally act as a cap on Scotland GN's rating, the operating companybenefits from regulatory ring-fencing provisions, which partly insulates it from the credit quality of SGN MidCo at the current rating



level (described in Appendix C, Considerations for ratings within a corporate family,of the Regulated Electric and Gas Networks ratingmethodology). As a result, the credit quality of Scotland GN is able to exceed that of the SGN MidCo group by one notch.

We consider that the covenant package in the SGN MidCo financing structure insulates the operating companies from shareholderloans at the ultimate holding company, SGN HoldCo. As a result, the debt at SGN HoldCo does not constrain the credit quality of theoperating companies.

Exhibit 16

Simplified group structure

Source: Company reports, Moody's Investors Service




Rating methodology and scorecard factorsOur assessment of Scotland GN’s credit quality is based on the Regulated Electric and Gas Networks rating methodology, published inMarch 2017. The scorecard-indicated outcome based on three years of historical financial metrics is A3, and is A3 in our 12-18 month

forward view. The assigned Baa1 rating reflects our expectation that key credit metrics will be weaker in RIIO-GD2 as well as the weakercredit quality of the consolidated SGN MidCo group.

Rating factorsScotland Gas Networks plc

Regulated Electric and Gas Networks Industry Grid [1][2]

Factor 1 : Regulatory Environment and Asset Ownership Model (40%) Measure Score Measure Score

a) Stability and Predictability of Regulatory Regime Aaa Aaa Aaa Aaa

b) Asset Ownership Model Aa Aa Aa Aa

c) Cost and Investment Recovery (Ability and Timeliness) A A A A

d) Revenue Risk Aa Aa Aa Aa

Factor 2 : Scale and Complexity of Capital Program (10%)

a) Scale and Complexity of Capital Program A A A A

Factor 3 : Financial Policy (10%)

a) Financial Policy Ba Ba Ba Ba

Factor 4 : Leverage and Coverage (40%)

a) Adjusted Interest Coverage Ratio (3 Year Avg) 1.7x Baa 1.4x - 2.1x Baa

b) Net Debt / RAB (3 Year Avg) 73.0% Baa 70% - 73% Baa

c) FFO / Net Debt (3 Year Avg) 11.5% Baa 8% - 14% Baa

d) RCF / Net Debt (3 Year Avg) 8.2% Baa 6% - 13% Baa

Rating:

Scorecard-indicated Outcome from Grid Factors 1-4 A3 A3

Rating Lift 0.5 0.5 0.5 0.5

a) Scorecard-indicated Outcome from Grid A3 A3

b) Actual Rating Assigned Baa1

Current

FY 31/03/2020

Moody's 12-18 Month Forward

View

As of May 2021 [3]

[1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations.[2] As of 31 March 2020.[3] This represents our forward view, not the view of the issuer, and unless noted in the text, does not incorporate significant acquisitions and divestitures.Source: Moody's Financial Metrics™

Ratings

Exhibit 18

Category Moody's RatingSCOTLAND GAS NETWORKS PLC

Outlook NegativeIssuer Rating -Dom Curr Baa1Senior Unsecured -Dom Curr Baa1





Appendix

Exhibit 19

Peer comparison tableScotland Gas Networks plc

FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE

Mar-18 Mar-19 Mar-20 Mar-18 Mar-19 Mar-20 Mar-18 Mar-19 Mar-20 Mar-18 Mar-19 Mar-20

Revenue 336 350 357 1,852 1,995 2,115 411 410 450 746 797 817

EBITDA 210 219 234 1,072 1,223 1,376 268 277 303 438 492 508

Total Debt 1,251 1,296 1,357 6,415 6,837 7,115 1,455 1,613 1,577 3,066 2,860 2,994

Net Debt 1,249 1,296 1,357 6,247 6,500 6,771 1,447 1,502 1,563 2,790 2,850 2,909

Adjusted Interest Coverage Ratio 1.9x 1.6x 1.6x 2.4x 4.5x 3.5x 1.9x 1.7x 2.2x 1.3x 1.6x 1.6x

Net Debt / Regulated Asset Base 72.4% 72.6% 74.2% 65.9% 66.6% 67.4% 67.4% 67.5% 67.7% 73.1% 72.1% 71.3%

FFO / Net Debt 11.5% 11.6% 11.4% 11.9% 14.3% 14.3% 12.2% 12.1% 13.2% 9.9% 11.2% 11.3%

RCF / Net Debt 6.0% 9.2% 9.3% 5.2% 7.8% 10.2% 5.9% 5.9% 7.0% 5.7% 8.8% 9.5%

Baa1 Negative Baa1 Stable Baa1 Stable Baa1 Negative

(in GBP million)

Scotland Gas Networks plc Cadent Gas Limited Northern Gas Networks Limited Southern Gas Networks plc

Source: Moody's Financial Metrics™

Exhibit 20

Moody's-adjusted net debt breakdownScotland Gas Networks plc

FYE FYE FYE FYE

(in GBP million) Mar-17 Mar-18 Mar-19 Mar-20

As Reported Total Debt 1,188 1,247 1,288 1,349

Leases 4 4 8 8

Moody's Adjusted Total Debt 1,192 1,251 1,296 1,357

Cash & Cash Equivalents (1) (2)

Moody's Adjusted Net Debt 1,191 1,249 1,296 1,357

All figures are calculated using Moody's estimates and standard adjustments.Source: Moody's Financial Metrics™

Exhibit 21

Moody's-adjusted funds from operations breakdownScotland Gas Networks plc

FYE FYE FYE FYE


As Reported Funds from Operations (FFO) 209 159 153 153

Pensions 7 5 6 5

Leases 1 1 2 2

Alignment FFO (10) (24) (10) (4)

Unusual Items - Cash Flow (7) (8) (8) (9)

Non-Standard Public Adjustments (39) 11 8 7

Moody's Adjusted Funds from Operations (FFO) 161 144 151 155




Exhibit 22

Moody's regulatory capital chargesScotland Gas Networks plcin GBP millions

FYE

Mar-17

FYE

Mar-18

FYE

Mar-19

FYE

Mar-20

Repex Allowance Classed as Fast Money by the Regulator 21 16 11 5

Regulatory Depreciation 75 84 95 107

Excess Fast/(Slow) Money 10 10 18 13

Operating Leases 1 1 2 2

Moody's Regulatory Capital Charges 107 110 126 127


Exhibit 23

Selected historic Moody's-adjusted financial dataScotland Gas Networks plc

FYE FYE FYE FYE


INCOME STATEMENT

Revenue 351 336 350 357

EBITDA 235 210 219 234

EBITDA margin % 66.8% 62.5% 62.6% 65.5%

EBIT 178 154 159 173

EBIT margin % 50.7% 45.9% 45.5% 48.5%

Interest Expense 45 39 42 44

Net income 130 96 98 80

BALANCE SHEET

Total Debt 1,192 1,251 1,296 1,357

Cash & Cash Equivalents 1 2

Net Debt 1,191 1,249 1,296 1,357

Net Property Plant and Equipment 1,858 1,918 2,007 2,085

Total Assets 2,451 2,160 2,247 2,422

CASH FLOW

Funds from Operations (FFO) 161 144 151 155

Cash Flow From Operations (CFO) 360 619 93 108

Dividends 65 69 31 28

Retained Cash Flow (RCF) 96 75 120 127

Capital Expenditures (108) (103) (136) (130)

Free Cash Flow (FCF) 187 447 (74) (50)

INTEREST COVERAGE

Adjusted Interest Coverage Ratio 2.2x 1.9x 1.6x 1.6x

LEVERAGE

FFO / Net Debt 13.5% 11.5% 11.6% 11.4%

RCF / Net Debt 8.0% 6.0% 9.2% 9.3%

FCF / Net Debt 15.7% 35.8% -5.7% -3.7%

Debt / EBITDA 5.1x 6.0x 5.9x 5.8x

Net Debt / EBITDA 5.1x 5.9x 5.9x 5.8x

Net Debt / Regulated Asset Base 72.2% 72.4% 72.6% 74.2%




Endnotes1 After adjusting for the move to a structurally lower measure of inflation, CPIH rather than RPI

2 Calculations based off company’s regulatory financial performance report 2019/20 forecasts of RIIO-1 total expenditure, inflated to 2018/19 prices, ascompared to RIIO-2 regulatory cost allowances as published in Ofgem’s regulatory model released on 3 February.

3 Available at https://assets.publishing.service.gov.uk/media/6040d8fce90e077dd6cf7425/Southern_Gas_Networks_plc_and_Scotland_Gas_Networks_plc_-_notice_of_appeal.pdf

4 Defined as the level of demand that, in a long series of winters, with connected load held at levels appropriate to the winter in question, would beexceeded in one out of 20 winters, with each winter counted only once

5 UK becomes the first major economy to pass net zero emissions law, 27 June 2019

6 See SGN's environmental strategy, https://www.sgn.co.uk/news/weve-launched-our-strategy-go-net-zero-2045, for more information.


https://assets.publishing.service.gov.uk/media/6040d8fce90e077dd6cf7425/Southern_Gas_Networks_plc_and_Scotland_Gas_Networks_plc_-_notice_of_appeal.pdf

https://assets.publishing.service.gov.uk/media/6040d8fce90e077dd6cf7425/Southern_Gas_Networks_plc_and_Scotland_Gas_Networks_plc_-_notice_of_appeal.pdf

https://www.gov.uk/government/news/uk-becomes-first-major-economy-to-pass-net-zero-emissions-law

https://www.sgn.co.uk/news/weve-launched-our-strategy-go-net-zero-2045


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Scotland Gas Networks plc - SGN