Fitch: UK infrastructure well hedged against temporary deflation

UK private finance initiative and offshore transmission projects are relatively well insulated against low inflation and the potential for short-term deflation through their use of contractual and synthetic hedging mechanisms, Fitch Ratings says. Prolonged low inflation, which is not our base case, would probably lead to downgrades, but these would probably be no more than one notch and would only affect some projects.

Inflation has a direct impact on the revenue streams of PFI and offshore transmission (OFTO) projects. Revenue is based on availability, through a base unitary charge indexed to inflation (typically RPI) and then adjusted for the availability and performance of the assets compared to target thresholds.

But this core exposure to inflation is typically significantly reduced by the use of one of three strategies. Some projects have set the weighting of inflation indexation in the revenue formula to match the proportion of the project's cost base that is exposed to inflation. Others achieve the same net result by entering into long-dated inflation swaps or by financing the project's debt requirement through inflation-linked debt.

An analysis of our portfolio of 32 UK PFI school and hospital ratings and credit opinions shows that a 1 percentage point fall in inflation generally reduces debt-service cover ratios (DSCRs) by less than 5 basis points. OFTOs are even more resilient, with none incurring more than a 2bp decrease.

A 5bp DSCR reduction for PFI projects is equivalent to 18% of the average debt-service buffer, or the gap between cash flows available for debt service compared to interest costs and principal repayments. Low inflation lasting for several years could therefore lead to downgrades for projects that were already at the low end of the threshold for their ratings, but these would be limited to one notch, all else being equal.

UK CPI inflation dropped to 0% in February. We expect UK inflation to average 0.3% in 2015, rising to 1.3% in 2016.