Southern Gas Networks plc - SGN

INFRASTRUCTURE AND PROJECT FINANCE

CREDIT OPINION12 May 2021

Update

RATINGS

Southern 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]

Southern Gas Networks plcUpdate following rating affirmation with negative outlookmaintained

SummaryThe credit quality of Southern Gas Networks plc (Southern GN, Baa1 negative) benefitsfrom (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 slightly above 70%.Strong operational performance during the previous RIIO-GD1 regulatory period supportedinterest cover metrics, which suffer because the company has less indexed linked debt thanpeers. However, in the current regulatory period (RIIO-GD2, which began on 1 April 2021),allowed returns are lower, due to the large cuts in allowed equity returns, and the scope foroperational 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 Southern GN to maintain an average adjusted interest coverageratio (AICR) during RIIO-GD2 of c. 1.3x (excluding timing differences), slightly below ourminimum guidance for the Baa1 rating level of 1.4x.

Exhibit 1

Absent an increase in regulatory allowances from a successful appeal or measures to protectcredit quality, Southern 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 post timing differences

Source: Moody's Investors Service

http://www.surveygizmo.com/s3/1133212/Rate-this-research?pubid=PBC_1281298

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

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

» Operating cash flows in FY2022 and FY2023 will continue to benefit from incentive income earnt in RIIO-GD1 as the rewards arepaid with a two year lag, boosting Southern GN's AICR by just over 0.2x in these years

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; impact accentuated by Southern GN's comparatively low levels of index linked debtversus regulatory assumptions

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

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

Rating outlookOn 23 April we affirmed Southern GN's ratings and maintained the negative outlook. The negative outlook reflects our expectationthat Southern GN will exhibit financial metrics, excluding timing differences, over the RIIO-GD2 period 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 Southern 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 the SGN group took measures to strengthen its balance sheet and/or materially reducefinancing costs

Factors that could lead to a downgrade

» If the CMA rejected SGN's appeals and we considered SGN was unlikely to take measures to protect Southern GN's credit quality ina timely manner thereafter

» The ratings could also be downgraded if (1) Southern 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 Southern 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

Southern Gas Networks plcTiming differences impact reported metrics (slightly depressing metrics in FY2021 and FY2022)

Mar-18 Mar-19 Mar-20 2021-proj. 2022-proj 2023-proj 2024-proj

Adjusted Interest Coverage Ratio 1.3x 1.6x 1.6x 1.4x 1.3x 1.2x 1.2x

Net Debt / RAV 73.1% 72.1% 71.3% 70.7% 72.4% 72.4% 72.5%

FFO / Net Debt 9.9% 11.2% 11.3% 10.7% 8.2% 8.0% 8.0%

RCF / Net Debt 5.7% 8.8% 9.5% 10.7% 7.2% 7.1% 7.1%

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.Source: Moody's Financial Metrics™

ProfileSouthern GN is the largest of the eight gas distribution networks (GDNs) in Great Britain by RAV, £4.1 billion at March 2021. SouthernGN provides gas distribution services to around 4.0 million customers through about 49,000 kilometres of gas pipelines in the south ofEngland, including the cities of Milton Keynes and Dover, and London boroughs south of the River Thames.

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

Southern 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, Scotland Gas Networks plc (Scotland 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/Scotland-Gas-Networks-plc-credit-rating-808742628


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. Southern 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

Southern GN service areaExhibit 5

Price control overview

Source: Energy Networks Association

GB Gas Distribution

Regulator/ Price Control Ofgem / RIIO-GD2

Regulated Business Southern Gas Networks plc

Term of price control April 2021 - March 2026

Allowed return on RAV

(vanilla real, CPIH stripped)

2.94% (2021-22)

c. 2.81% average for RIIO-GD2

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

(c. 10.6% achieved in RIIO-GD1)

Regulated Asset Value (March 2021) £4.14 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 Southern 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 ...Southern 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 Southern GN's operational cash flows by around £40 millionper annum in RIIO-GD2, equivalent to almost 40% of the company's FY2020 interest expense. The overall reduction in regulatoryreturn (RAV * allowed return) is smaller, around £10 million per annum, due to (1) the lower regulatory gearing assumption for RIIO-GD2 than RIIO-GD1 (60% compared to 65%); and (2) the higher regulatory cost of debt allowance in RIIO-GD2 than RIIO-GD1(largely due to the move to a structurally lower measure of inflation, CPIH rather than RPI).

Exhibit 8

Southern 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 2.94 2.83 2.77 2.75 2.78

0

1

2

3

4

5

6

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 debtSouthern 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 (Cadent Gas, Baa1 stable), in part due to the lower proportion of inflation-linked debtin its capital structure. As Exhibit 1 shows, with the cut in regulatory return in RIIO-GD2, we expect Southern GN to maintain a basereturn significantly below 1.4x, the minimum guidance for the Baa1 rating, unless there is an increase in regulatory allowed returnsfollowing 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

Southern GN's cash cost of debt allowance will fall over RIIO-GD2but remain higher than in FY2021Evolution of Southern 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 2.55

2.38 2.221.91

1.58

1.09

2.051.88 1.73 1.63 1.58

-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 26Regulatory year commencing April

20

iBoxx 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, 25 bps for SouthernGN) 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


Very limited scope for operational outperformance due to challenging regulatory cost allowancesSouthern GN has a track record of strong operating performance, evidenced by it outperforming cost allowances by around 13% inRIIO-GD1, primarily due to its performance on operating expenditure (both direct and indirect) and replacement expenditure (repex).

However, we believe that the scope for Southern GN to outperform regulatory allowances in RIIO-GD2 is very limited as the regulatorydetermination currently stands. This is because (1) regulatory allowances are 5.4% lower per annum than actual expenditure in RIIO-GD12 (8.7% for repex and 2.2% for all other totex) and assume ongoing annual productivity gains averaging 1.2%, significantly abovethe levels in prior regulatory determinations for UK regulated utilities (below 1% in RIIO-1 distribution controls); and (2) Ofgemconcluded from its benchmark analysis that the company was the second least efficient company in the sector and made significantdeductions from Southern GN's regulatory allowances. The latter accounts for the majority of the cut (65%, after considering volumeadjustments, or £147 million in 2018-19 prices) to Southern GN's requested cost allowances, compared to 31% for peers. We note thata successful appeal of the outperformance wedge would offset 2% totex underperformance.

Exhibit 11

Southern GN had the second largest cut in baseline allowances of all the GDNs on a comparable basis

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, Southern GN earnt around £16 million per annum (in 2019/20 prices, around 5% of Funds From Operations over thelast three financial years) from output delivery incentives carrying financial rewards or penalties (ODI-Fs), primarily on the broadmeasure of customer satisfaction and shrinkage and environmental emissions. With significantly more demanding regulatory targetsand different calibration of ODI-Fs with reduced reward opportunities in RIIO-GD2 than in RIIO-GD1, particularly on the customersatisfaction survey and shrinkage incentive, we expect earnt incentive income from ODI-Fs to be lower in RIIO-GD2. However,Southern GN's operating cash flows in FY2022 and FY2023 will continue to benefit from incentive income earnt in RIIO-GD1 as therewards are paid with a two-year lag, benefiting AICR by just over 0.2x in these years.

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 tougherbenchmark 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 licence modifications to enactOfgem's RIIO-2 price control decision.

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 appeal body will make its finaldecision by 30 October (it decided in April to utilise the one month extension to the statutory deadline) with its provisional determinationscheduled for early August.

The energy network appeals follow the successful appeals by four UK water companies of Ofwat's PR19 determination, see CMA final decisionis credit positive for appellants, 18 March, for more information. Most of SGN's appeal grounds have some degree of overlap with the CMA'sfinal decision on PR19.

Our projections (see Exhibit 1) do not assume any upside from the appeals, but we consider that some upside is likely. Southern GN's revenuesover RIIO-GD2 would rise by c. £34 million (2018-19 prices), c. 2% of current regulatory totex allowances, if the (1) outperformance wedgewas overturned (£19.5 million), adding c. 0.04x to AICR metrics; (2) base ongoing efficiency was lowered to 1% from 1.2% (£14.3 million),either through the removal of additional innovation challenge or using the PR19 value. Incremental upside, beyond these two areas, of at least£40 million, would be contingent on the CMA enacting changes to Ofgem's cost of equity methodology as per its decision on PR19 appeal,see Exhibit 7, but without a downwards beta adjustment.

ESG considerationsLong-term decline in gas demandAlthough Southern 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, Southern 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 forSouthern 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 Southern 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 for



SGN'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-19Southern GN, like other European energy networks, has low exposure to the impact of covid-19. Under the regulatory framework, anydeviations between Southern 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 Southern 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 Scotland GN, not maturing until March 2025 and being fully undrawn as of March 2021. We assess refinancing riskas low with the company having no further maturities until October 2023.

Exhibit 15

External debt maturity profile by regulatory periodAs of March 2021

0

100

200

300

400

500

600

700

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

RIIO-GD2 RIIO-GD3 RIIO-GD4 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 Southern 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 stronger interest coverage metrics at Scotland GN thanSouthern GN, we expect the consolidated SGN group to exhibit only slightly weaker AICR metrics (excluding timing differences) overRIIO-GD2 than Southern GN.

Although the weaker credit quality of SGN MidCo group would normally act as a cap on Southern 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 ratinglevel (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 Southern 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 Southern GN’s credit quality is based on the rating methodology for Regulated Electric and Gas Networks,published in March 2017. The scorecard-indicated outcome is Baa1, in line with the assigned rating.

Rating factorsSouthern 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) 1.5x Baa 1.4x - 1.6x Baa

b) Net Debt / RAB (3 Year Avg) 72.2% Baa 70% - 73% Baa

c) FFO / Net Debt (3 Year Avg) 10.8% Ba 8% - 11% Ba

d) RCF / Net Debt (3 Year Avg) 8.0% Baa 7% - 11% Baa

Rating:

Scorecard-indicated Outcome from Grid Factors 1-4 Baa1 Baa1

Rating Lift 0.5 0.5 0.5 0.5

a) Scorecard-indicated Outcome from Grid Baa1 Baa1

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 31/03/2020.[3] This represents Moody's 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 RatingSOUTHERN GAS NETWORKS PLC

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





Appendix

Exhibit 19

Peer comparison table

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

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

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

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

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

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

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

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

(in GBP million)

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

Baa1 Negative Baa1 Stable Baa1 Stable Baa1 Negative

Source: Moody's Financial Metrics™

Exhibit 20

Moody's-adjusted net debt breakdownSouthern Gas Networks plc

FYE FYE FYE FYE

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

As Reported Total Debt 2,619 3,053 2,848 2,980

Leases 11 13 12 14

Moody's Adjusted Total Debt 2,630 3,066 2,860 2,994

Cash & Cash Equivalents (7) (276) (10) (85)

Moody's Adjusted Net Debt 2,623 2,790 2,850 2,909

Source: Moody's Financial Metrics™

Exhibit 21

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

FYE FYE FYE FYE


As Reported Funds from Operations (FFO) 422 273 325 316

Pensions 10 7 11 9

Leases 1 2 3 2

Alignment FFO (9) (3) (20) 12

Unusual Items - Cash Flow (11) (11) (13) (13)

Non-Standard Public Adjustments (95) 8 13 3

Moody's Adjusted Funds from Operations (FFO) 317 275 319 329

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



Exhibit 22

Moody's regulatory capital chargesSouthern 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 57 44 31 15

Regulatory Depreciation 166 184 207 232

Excess Fast/(Slow) Money 8 14 8 16

Operating Leases 1 2 3 3

Moody's Regulatory Capital Charges 232 244 248 265


Exhibit 23

Selected historical Moody's-adjusted financial dataSouthern Gas Networks plc

FYE FYE FYE FYE


INCOME STATEMENT

Revenue 758 746 797 817

EBITDA 475 438 492 508

EBITDA margin % 62.7% 58.7% 61.7% 62.2%

EBIT 362 324 371 384

EBIT margin % 47.8% 43.5% 46.6% 46.9%

Interest Expense 100 102 110 104

Net income 259 184 218 168

BALANCE SHEET

Total Debt 2,630 3,066 2,860 2,994

Cash & Cash Equivalents 7 276 10 85

Net Debt 2,623 2,790 2,850 2,909

Regulated Asset Base (RAB) 3,648 3,814 3,950 4,078

Total Assets 5,316 4,968 4,874 5,224

CASH FLOW

Funds from Operations (FFO) 317 275 319 329

Cash Flow From Operations (CFO) 280 1,175 294 330

Dividends 135 117 68 53

Retained Cash Flow (RCF) 182 158 251 276

Capital Expenditures (244) (268) (264) (296)

Free Cash Flow (FCF) (99) 790 (38) (19)

INTEREST COVERAGE

Adjusted Interest Coverage Ratio 1.9x 1.3x 1.6x 1.6x

LEVERAGE

FFO / Net Debt 12.1% 9.9% 11.2% 11.3%

RCF / Net Debt 6.9% 5.7% 8.8% 9.5%

FCF / Net Debt -3.8% 28.3% -1.3% -0.7%

Debt / EBITDA 5.5x 7.0x 5.8x 5.9x

Net Debt / EBITDA 5.5x 6.4x 5.8x 5.7x

Net Debt / Regulated Asset Base 71.9% 73.1% 72.1% 71.3%

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



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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Southern Gas Networks plc - SGN