TEXT - S&P revises Ontario Power Generation outlook to negative
Overview -- We are revising our outlook on Ontario Power Generation Inc. (OPG) to negative from stable. -- At the same time, we are affirming our ratings, including our 'A-' long-term corporate credit rating, on the company. -- The outlook revision reflects the revision of our stand-alone credit profile on OPG to 'bbb-' from 'bbb'. -- The ratings reflect our opinion of the company's strong business risk profile and significant financial risk profile. Rating Action On Nov. 27, 2012, Standard & Poor's Ratings Services revised its outlook on Ontario Power Generation Inc. (OPG) to negative from stable. At the same time, Standard & Poor's affirmed its ratings, including its 'A-' long-term corporate credit rating, on the company. The outlook revision reflects the revision of our stand-alone credit profile (SACP) to 'bbb-' from 'bbb'. Based on our criteria for government-related entities, based on a 'bbb-' standalone credit profile and a "high" probability of extraordinary government support, the negative outlook reflects the negative outlook on the utility's shareholder, the Province of Ontario (AA-/Negative/A-1+). A further lowering of the SACP or a downgrade on the province would lead to a negative rating action on OPG. Rationale The SACP revision reflects our view that OPG's credit metrics could weaken in the near-to-medium term. The company is continuing with a number of projects that require a significant amount of capital expenditure in the next two years. In particular we forecast that the Darlington nuclear facility refurbishment together with the Lower Mattagami project will require approximately C$1 billion in capital expenditures in each of the next two years. This is in addition to the other projects that OPG is working on along with sustaining capital expenditure. We view this capital expenditure in a regulatory context, which provides limited cash flow relief during construction for multiyear projects and a balanced-but measured-perspective on yearly rate applications. Accordingly, the timing difference between the regulatory asset's development (with the consequential debt) and the start of cash flow in the regulatory environment (which has allowed moderate rate increases) could stress financial metrics. The ratings on OPG, which Ontario owns, reflect Standard & Poor's opinion of the regulatory oversight of the utility's baseload nuclear and hydroelectric assets; a diverse generation portfolio; and dominant market position in Ontario. Weak cash flow metrics and exposure to regulatory delay and cost overruns related to new construction and refurbishment of existing facilities offset the company's credit strengths, in our view. Exposure to merchant electricity prices and volume related to OPG's unregulated business further constrain the SACP. We rate management as "fair" under our management and governance criteria. The company borrows about 80% of its C$4.9 billion reported consolidated debt as of Sept. 30, 2012, from the government shareholder, through Ontario Electricity Financial Corp. (OEFC). We base the 'A-' rating on OPG's SACP, which we assess at 'bbb-', and our opinion that the ratings on OPG and Ontario are linked. We assess that there is a "high" likelihood that the government shareholder would provide timely and sufficient extraordinary support in the event of financial distress. This reflects our views that OPG's role is "important" to Ontario, that the utility plays a major role in the government's energy policy; and that the link between the utility and the province is "very strong", reflecting ownership relationship, ongoing financial support from OEFC, and the province's strong influence in the company's investment decisions. In our view, OPG's business risk profile benefits from having about 77% of its EBITDA in 2011 supported by regulated sources. These sources include nuclear and baseload hydroelectric assets that the Ontario Energy Board (OEB) regulates as well as regulated nuclear waste management. Assurance of cost recovery and a predictable, albeit moderate, return for these assets is a positive credit factor. Historically, although the OEB decisions have led to more moderate returns for OPG, given the discretion that the company has with respect to its capital expenditure and the resultant level of debt it was able to mitigate the impact of lower revenues. However, the company has reached an inflection point in its capital plans where significant expenditures for such things as the Darlington facility refurbishment and the Lower Mattagami project are required. We believe that these projects will put significant strain on credit metrics for the next two years. The fuel diversity and large number of generating units in OPG's generation portfolio mitigate the risk of operational disruptions and enhance its business position, in our opinion. As of Sept. 30, 2012, the portfolio of assets that the company owns and operates includes: -- 6,606 megawatts (MW) of baseload regulated nuclear generation; -- 6,996 MW of predominantly run-of-the-river hydroelectric generation, of which 3,312 MW is regulated; and -- 5,447 MW of intermediate unregulated thermal generation (projected to shut down by 2014). We believe OPG has a strong competitive position. The company dominates the Ontario electricity market, producing 85 terawatt-hours (TWh; most of it baseload) of the 142 TWh of electricity consumption in the province in 2011. Its unregulated hydro assets typically enjoy a competitive advantage compared with higher marginal cost gas-fired alternatives. Constraining OPG's unregulated cash flows, in our view, are the company's exposure to the wholesale electricity price and volume risk due to fluctuations in Ontario demand, the inherent uncertainty of available water flows, and competitively priced imports from neighboring markets. Wholesale electricity prices have struggled in 2012, with the weighted average Hourly Ontario Electricity Price at C$24 per MW-hour (MWh) for the nine months ended Sept. 30, 2012, compared with the C$32 per MWh in 2011. Technical challenges associated with key components of nuclear facilities have the potential to expose the units to lengthy outages, hurting cash flow performance and increasing capital demands. OPG's nuclear liability risk-sharing agreement with Ontario limits the company's used nuclear fuel liabilities and partially mitigates the operating challenges. In implementing its energy policy favoring renewable energy generation to replace the less eco-friendly coal-fired generation facilities, the province has directed OPG toward investments in projects on various occasions. It also required the utility to shut down the remaining coal-fired plants by 2014. Along with these directives, the government has provided ongoing support to OPG through loans from OEFC and long-term power purchase agreements with the Ontario Power Authority to support the company's other projects. It also provides OPG with a contingency support agreement to cover operating costs and a modest return on investments of the coal-fired facilities until complete closure in 2014. We regard these ongoing supports as important mitigating factors to the company's business risk profile. We believe OPG's stand-alone financial risk profile is significant. We believe stand-alone cash flow metrics are generally weak, partially as a result of the material postretirement benefit adjustments and modest return on investments. Adjusted funds from operations (AFFO) interest coverage was 2.7x and FFO-to-total debt was 9.1% for the 12 months ended Sept. 30, 2012. AFFO, in our definition, deducts the contribution to nuclear waste and decommissioning funds, which we regard as a cost of ongoing operations. We expect any improving trend that might emerge in the next three years to be gradual. We forecast that AFFO for the next two years will be approximately C$800 million in each of the next two years. Based on the significant capital expenditure required, we believe that AFFO-to-debt could fall below 9% in each of the next two years. Liquidity OPG's liquidity is adequate under our criteria, and should be sufficient to cover cash uses in the next 12 months. Standard & Poor's bases its liquidity assessment on the following factors and assumptions: -- We expect that the company's liquidity sources of about C$2.9 billion in the next 12-18 months will exceed its uses by about 1.6x. -- Available cash resources include our expectation of annual cash flow from operations of about C$900 million, and available credit facilities of C$1.9 billion as of Sept. 30, 2012. The committed and available credit facilities comprise a C$1 billion maturing May 2017, a C$700 million bank credit facility to support initial construction of the Lower Mattagami project, and a C$700 million OEFC facility for Lower Mattagami. -- Projected uses of cash in the next 12 months include a sizable capital expenditure of about C$1.7 billion. We expect that the utility will not pay out dividends in the foreseeable future and future debt maturities do not present a material concern, given the shareholder's practice of refinancing notes payable at their due dates. Outlook The negative outlook reflects our view of the 'bbb-' SACP, the high likelihood of provincial support, and the negative outlook on the province. Although we recognize that OPG's cash flow adequacy will be weaker in the next two years due to substantial capital expenditure on regulated and contracted projects, we believe that the SACP could be lowered if we expect OPG's adjusted FFO-to-total debt to stay below 8%-10% or adjusted FFO interest coverage weakens to below 3.0x. This could result from unfavorable rate decisions, operational issues resulting in unexpected outages in its generation facilities, or a move toward a more aggressive financial policy (including extended significant debt financed capital expenditure). A decline in the SACP to 'bb+' would result in a downgrade on OPG. For the SACP to move a notch higher, we believe OPG would need to improve significantly the level and stability of is overall cash flow strength comfortably above 10%-12%. This could result from an equity injection from the province which we consider to be highly unlikely. It could also result from some form of additional regulatory cash flow support during the upcoming period of high capital spending on large projects that we have seen for other Canadian utilities in a similar position. We link the ratings on the utility and those on the province through our enhanced government-related entity methodology. All else being equal, a one-notch downgrade to Ontario would result in a one-notch downgrade in OPG. An outlook revision to stable on the province could result in a similar outlook revision on OPG. A change in the relationship with the government shareholder, which includes changes in ownership, could move the ratings in either direction. Related Criteria And Research -- Methodology: Management and Governance Credit Factors for Corporate Entities and Insurers, Nov. 13, 2012 -- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Rating Government-Related Entities: Methodology And Assumptions, Dec. 9, 2010 -- Key Credit Factors: Business And Financial Risks In The Investor-Owned Utilities Industry, Nov. 26, 2008 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ontario Power Generation Inc. To From Outlook Revised To Negative Corporate credit rating A-/Negative/-- A-/Stable/-- Ratings Affirmed Commercial paper Canada scale A-1(Low)
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