Fitch Ratings has affirmed Shanghai Electric Power Co., Ltd.'s (SEP) Long-Term Foreign-Currency Issuer Default Rating (IDR) and senior unsecured rating at 'A-'.

The Outlook is Stable.

SEP is rated one notch down from its 52% parent, State Power Investment Corporation Limited (SPIC, A/Stable), under a 'strong parent, weak subsidiary' approach in accordance with Fitch's Parent and Subsidiary Linkage Rating Criteria. We assess that SPIC has 'Medium' legal, strategic and operational incentives to support SEP.

SEP is one of SPIC's most strategically important subsidiaries; it acts as the parent's base in eastern China, accounting for around 10% of SPIC's total power capacity as of end-2021. It is also one of three independent power producers in Shanghai and SPIC group's major overseas investment platform and coal-import sourcing platform.

Key Rating Drivers

'Medium' Strategic Incentive for Parental Support: We believe SEP has 'Medium' competitive advantages and growth potential for its parent, which offset its 'Low' financial contribution; we expect SEP to account for around 10% of SPIC's operating EBITDA in the medium term. SEP plays a critical role in safeguarding power supply in China's finance center on behalf of its parent as its only subsidiary that operates in the country's largest city. SEP's strategic importance to SPIC is also evident from the tangible support from SPIC throughout the years, including a CNY1.2 billion equity injection in 2022.

'Medium' Operational Incentive for Parental Support: We assess 'Medium' operational incentive between SEP and SPIC, reflecting 'Medium' management and brand overlap. SEP has some board directors that also act as senior managers in the group and bears the SPIC brand name on certain occasions. We assess operational synergy as 'low' due to limited vertical integration.

'Medium' Legal Incentive for Parental Support: We assess SPIC's legal incentive to support SEP at 'Medium', as the parent has outstanding public bonds with cross-default clauses that cover SEP. However, we believe the guarantee sub-factor under legal incentive is 'Low', as the parent does not guarantee the subsidiary's debt.

Dark Spread to Recover: We expect SEP's dark spread between tariffs and unit fuel costs to recover as tariffs rise, after reaching a record low in 2021 on surging coal prices. However, persistently high coal prices in 2022 will keep dark spread below pre-2021 levels. SEP sells a large proportion of power under annual trading contracts, with tariffs exceeding the benchmark by around 20%. However, this was sold at a discount in 2021. Tariffs under monthly and spot trading contracts were also high.

Strong Renewables; Enhanced Business Profile: SEP is expanding its renewable power business through greenfield projects and acquisitions. We expect the share of renewables in SEP's fuel mix to rise by 15pp to 55% by 2025, from 40% at end-2021. Higher renewable power capacity will enhance SEP's business profile by improving earnings predictability. Renewable projects collect long-term fixed tariffs, enjoy dispatch priority, and are not exposed to fuel-cost volatility.

High Leverage on Large Capex: We estimate SEP's EBITDA net leverage to improve to around 10x in 2022, from over 14x in 2021, due to a better profit margin, faster collection of renewable subsidies and an equity injection from the parent. Leverage is likely to trend down further in 2023-2025 on a recovery of dark spread on normalised coal prices and rising contribution from renewable energy. However, leverage will remain high due to large capex on renewable energy in the medium term, but should be mitigated by a healthy liquidity profile, supported by strong access to the bank and capital market.

Derivation Summary

SEP is rated one notch below its parent, SPIC, due to 'Medium' legal, strategic and operational incentives for parental support under Fitch's Parent and Subsidiary Linkage Rating Criteria. The notching is wider than that for Huaneng Power International, Inc. (A/Stable), whose ratings are equalised with those of its parent, China Huaneng Group Co., Ltd. (A/Stable), due to 'High' operational and strategic incentives for parental support.

Huaneng International makes a larger financial contribution to its group, and generates over 40% of the group's EBITDA under normalised coal prices. This is much higher than the approximate 10% EBITDA contribution of SEP. Huaneng International also shoulders a higher responsibility in its parent's energy transition, which includes investing around half of the group's renewable energy in the 14th five-year plan period (2021-2025) and co-investing in Huaneng's nuclear power projects.

The 'High' operational incentive for Huaneng International's parent to provide support reflects greater vertical integration between Huaneng International and its parent's coal mining business, as well as greater control by Huaneng group, as Huaneng International is the group's key listing platform.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Installed capacity to reach 32GW by 2025 (2021: 19GW)

Thermal utilisation hours to trend down in the medium-term due to greater renewable energy output

Average tariff for Chinese coal-fired plants to increase in 2022 due to high fuel costs, trending down thereafter

Solar and wind power utilisation hours to follow historical levels, with the tariff trending down as subsidies are removed

Coal prices to follow the movement of Fitch's price-deck assumptions

Annual capex of around CNY12 billion-25 billion in 2022-2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Positive rating action on SPIC, provided SPIC's incentive to support SEP remain intact.

Strengthening incentive for parental support

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Negative rating action on SPIC

Weakening incentive for parental support

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Funding Access: SEP's liquidity profile is supported by its strong funding capability in the bank and debt market as a key subsidiary of SPIC. It had CNY30.3 billion in short-term debt, including the current portion of long-term debt, as of June-2022, compared with CNY10.0 billion in readily available cash. SEP also had CNY198.9 billion in bank credit facilities, of which around 70% were unutilised, and had raised CNY1.2 billion from its parent in 2022. We expect SEP's large unused external credit facility and internal lending arrangement within SPIC group to be sufficient to address liquidity needs.

Issuer Profile

SEP is a power generation company, with most of its assets in east China. It had total operating capacity of 19GW at end-2021, of which 45% came from coal-fired power plants.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

SEP is rated one notch below its parent, SPIC, under Fitch's Parent and Subsidiary Linkage Rating Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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