Scotia Gas Networks has completed Europe's first securitisation of gas distribution networks by wrapping up a £2.2 billion placement in the capital markets. The proceeds will take out the £2.082 billion debt used in the £3.162 billion purchase of Southern Gas Networks and Scotland Gas Networks from National Grid Transco in June.

The acquirer, Scotia, is 50% owned by Scottish and Southern Energy with the remaining equity split equally between Borealis Infrastructure Europe and Ontario Teachers' Pension Plan.

Although the deal is set against a regulated environment and has similar characteristics to the structured refinancings that spread throughout the UK water sector, the risks are slightly higher.

Moody's stipulated that to make a Baa1 rating, corporates backing gas distribution networks would need to have a maximum debt-to-regulated asset value (RAV) of 70%. The Scotland and Southern networks are forecast to operate in the low 80% and high 70% so the bonds were rated Baa2.

The two principal uncertainties in the deal are the lack of management record and regulatory risk. The first is offset by the presence of Scottish and Southern Energy (SEE) – at present the most efficient player in the UK electricity market. If Scotia hits its efficiency targets for the two networks it can boost its allowed return of 6.25% on RAV.

The regulatory risk for gas is higher than other UK utilities. For example it is unclear how Ofgem will deal with capital expenditure that goes over its assumptions.

Although the business risk of gas is likely to converge with the other regulated industries – gas will always need stronger ratios given the commodity's volatility.

This will be of small concern to Scotia Gas paper holders, however, given that all 11 tranches are monoline wrapped to AAA by Ambac, FSA and XL. The bond issue – underwritten by Barclays Capital, Citigroup, Dresdner Kleinwort Wasserstein and RBS – was carved into tranches of varying maturities, across regulatory price reviews, to have as broad an appeal as possible to the market. The issue is also split between fixed and floating rate notes.

That all of the issue was wrapped mirrors current market conditions. Institutions want new-issue BBB rated paper at around 100bp, but with monoline wraps falling from the 25-35bp range of 18 months ago to 15-20bp now, and AAA paper currently trading at 50-60bp, there is a 20-30bp arbitrage play on wrapping an underlying BBB. "Institutions approached us saying they were willing to take unwrapped paper," said one of the bookrunners, "But unless they drop their expectations by 20bp – it's really a no-brainer – 20bp across £2 billion over 30-years stacks up to a large saving."

The American monolines, including FGIC and MBIA which were not on the issue, are very keen on the UK regulatory story. So it was of little surprise that when the bookrunners approached the guarantors with the key structural features of the refinancing for what was effectively an auction, very competitive terms ensued.

The key structural feature is the gearing covenant that stipulates that if debt exceeds 77.5% RAV dividend payments are blocked and if gearing exceeds 95% an event of default is triggered.

Regulators in the past, predominantly Ofwat (but similarly Ofgem), have been very protective of lenders to utilities, and have made sure that corporates under their guidance have been able to comfortably fund their capex requirements. Wrappers have taken huge comfort from the regulators' policing role. The regulators are not afraid to resort to big-stick tactics on utilities with sliding ratings – for example, Northumbria lost its investment grade and was warned cash returns could be capped.

The wrapped arbitrage play is likely to continue as long as the monoline appetite remains (despite the tight margins, monolines account for their commission from on a Net Present Value, so their fees on long-dated paper, 25 years plus, are still quite substantial). Or an inflection in the credit cycle: the spread between BBB and AAA paper is now as low as 50bp, whereas two years ago it was 100bp, so there are now difficult risk/reward decisions to be made by institutional investors – is, say, 40bp enough of a reward for a big jump in risk?

But for the time being monolines dominate. Next on the block is likely to be Northern Gas Networks.

Scotia Gas Networks
Status: Launched 6 October, closed 21 October
Size: £2.2 billion
Shareholders: Scottish and Southern Energy (50%); Borealis Infrastructure Europe (25%) and Ontario Teachers' Pension Plan (25%)
Bookrunners: Barclays Capital, Citigroup, Dresdner Kleinwort Wasserstein and RBS
Monolines: Ambac; FSA; XL
Issuer legal counsel: Freshfields (English law); Dundas & Wilson (Scottish law)
Dealers counsel: Allen & Overy
Monoline counsel: Linklaters