. The credit metrics of South African power utility ESKOM Holdings SOC Ltd. (ESKOM) are weakening due to insufficient tariff increases to fund the company's large capital expenditure program, and to rising operating costs.
. At the same time, we believe that ESKOM's business risk has increased due to regulatory risk, construction delays, and weakened profitability.
. As a result, we are lowering ESKOM's stand-alone credit profile (SACP) to 'b-' from 'b', and revising the company's business risk profile to "weak" from "fair."
. In addition, we are affirming our 'BBB' foreign and local currency issuer credit ratings on ESKOM, in line with our criteria on government-related entities, and to reflect our view that the likelihood of extraordinary government support for ESKOM remains "extremely high."
. The negative outlook reflects the possibility of a downgrade if ESKOM's SACP weakens further; if we downgrade the Republic of South Africa; or if we revise downward our assessment of the likelihood of extraordinary government support.

LONDON (Standard & Poor's) Oct. 14, 2013--Standard & Poor's Ratings Services said today that it affirmed its 'BBB' foreign and local currency issuer credit ratings on South Africa-based power utility ESKOM Holdings SOC Ltd. (ESKOM). At the same time, we affirmed our 'zaAA/zaA-1' long- and short-term South Africa national scale ratings on ESKOM.

In addition, we revised downward our stand-alone credit profile (SACP) on ESKOM to 'b-' from 'b'.

The downward revision of ESKOM's SACP reflects a weakening in ESKOM's credit metrics due to its largely debt-funded capital expenditure (capex) program being insufficiently covered by tariff increases, and to rising operating costs. The downward revision of the SACP also reflects our view of rising business risk for ESKOM, in light of increased regulatory and operating risk, and weakened profitability owing to an unfavorable regulatory decision.

The affirmation of the issuer credit ratings reflects our criteria on government-related entities (GREs), and our view that the likelihood of extraordinary state support for ESKOM remains "extremely high." Our GRE criteria specify an issuer credit rating of 'BBB' on the GRE if the likelihood of government support is "extremely high," the local currency rating on the sovereign is 'A-', and the SACP on the GRE is either 'b' or 'b-'.

We understand that the energy regulator's decision for the third multi-year price determination (MYPD3)--which runs from 2013-2014 to 2017-2018--will result in an average annual tariff increase of 8%, which is half the amount that ESKOM requested to support its large capex program. In addition, ESKOM faces continued cost pressures, due to construction delays and rising primary energy and labor costs. Consequently, we anticipate that ESKOM's credit metrics will deteriorate further over the course of MYPD3 such that they are no longer consistent with the previous SACP of 'b'.

In our opinion, ESKOM is adequately funded for the next two years. However, in the last three years of MYPD3, we believe that the company will require additional funding of about South African rand (ZAR) 50 billion. This assumes that ESKOM successfully completes a wide-ranging cost-cutting program, and recovers costs that the regulator considers were prudently incurred through a regulatory clearing account. We understand that ESKOM is discussing with its stakeholders opportunities to strengthen its credit metrics, which may include, among other options, new equity-like instruments. We will follow these discussions closely, because they will help inform our opinion on whether our assessment of an "extremely high" likelihood of extraordinary government support for ESKOM remains appropriate.

We have revised downward our assessment of ESKOM's business risk profile to "weak" from "fair" previously. The change reflects our opinion of negative regulatory intervention that will further delay a transition to cost-reflective tariffs and will constrain ESKOM's profitability. It also reflects our opinion of continued heightened operational risk, because South Africa's reserve margin remains tight.

Our view of an "extremely high" likelihood of extraordinary government support is based on our assessment of ESKOM's:
. "Very important" role as the dominant electricity provider in South Africa. In our view, ESKOM plays an important role in meeting the government's key economic, social, and political objectives; and
. "Integral" link to the South African government, reflecting its full ownership of ESKOM and the explicit support provided through guarantees on debt and a capital injection.

There is possibility of us lowering the ratings on ESKOM if any of the following occur:
. A downward revision of the SACP. Assuming no change in our assessment of the likelihood of extraordinary government support, and no downgrade of the sovereign, a downward revision of the SACP would likely result in a downgrade of one notch;
. A downgrade of the Republic of South Africa. A one-notch downgrade of South Africa would likely result in a one-notch downgrade of ESKOM, assuming no change in the SACP or our assessment of the likelihood of government support;
. A downward revision of our assessment of the likelihood of extraordinary support to "very high." All else remaining equal, this could result in us downgrading ESKOM by multiple notches to the mid 'BB' category, in accordance with our criteria on GREs.

We could revise the outlook to stable if ESKOM's credit metrics were to stabilize and strengthen significantly. An outlook revision to stable is also contingent on us revising the outlook on the sovereign to stable, and the likelihood of extraordinary government support for ESKOM remaining "extremely high."

We consider an upgrade for ESKOM as unlikely over the intermediate term, due to the business and financial challenges the company faces and the negative rating pressure on the sovereign.