DBRS Confirms Hydro One Inc. at A (high) and R-1 (middle), Stable Trends

DBRS has today confirmed the Senior Unsecured Debentures rating of Hydro One Inc. (Hydro One or the Company) at A (high) and its Commercial Paper rating at R-1 (middle), both with Stable trends. The rating confirmations reflect Hydro One’s low level of business risk, stemming from its regulated electric power transmission and distribution operations, and its solid financial profile.

The Company’s largest challenge over the medium term continues to be its significant ongoing capital expenditures and the resultant free cash flow deficits. Capital expenditures are expected to be approximately $5.6 billion over the next three years. Hydro One has decreased its planned capital expenditures as a result of ongoing discussions with the Ontario Power Authority (OPA) on future transmission project needs and priorities, as well as the Ontario Energy Board’s (OEB) 2010 distribution rate decision. The Company announced that capital expenditures are expected to decrease by $400 million, $100 million and $250 million, for 2010, 2011 and 2012, respectively. Therefore, DBRS expects annual capital expenditures could exceed operating cash flows by approximately $600 million to $900 million per year, over the next three years.

The capital expenditures primarily reflect investments to expand, refurbish or replace transmission infrastructure, which is consistent with government policy such as the Green Energy Act, Smart Meters and the Smart Grid and other initiatives contemplated by the OPA. The level of investment also reflects the continued mass deployment of smart meters within Hydro One’s distribution businesses, which began in 2007 and will be completed by 2011.

The free cash flow deficits are expected to be entirely debt financed, continuing to put temporary pressure on the Company’s balance sheet and coverage ratios as the invested capital is not included in the rate base until the completion of the projects. Also, given that a material portion of Hydro One’s capital expenditures are for large transmission projects that involve lengthy construction times and the potential for delays caused by the intervenor process, timely project completion within budget is important. DBRS views the pressure on the Company’s balance sheet and coverage metrics as temporary with the expectation of a modest improvement over the medium term. Financial metrics are not expected to deteriorate materially from the current levels, and remain within a range supportive of the assigned ratings given the temporary nature of the decline in coverage metrics, and the low level of business risk. DBRS expects Hydro One to continue its trend and manage dividends in order to support its heightened capital program.

Hydro One recently strengthened its already substantial liquidity arrangements. In January 2010, the Company purchased $250 million Province of Ontario Floating Rate Notes maturing in 2014 as a form of alternate liquidity to supplement its bank credit facilities. Additionally, in February 2010, Hydro One entered into a total of $1,250 million committed revolving credit facility which supports its commercial paper program and matures June 2013.

DBRS notes that in December 2009, the OEB changed its methodology in calculating ROEs, which has resulted in an increase in the ROE to 9.85%, as per the OEB letter on Cost of Capital Parameter Updates for 2010 Cost of Service Applications dated February 24, 2010, representative of market conditions and rising bond yields. Hydro One applied for the higher ROEs to be applied to the 2010 rates for both the transmission and distribution segments. The OEB granted Hydro One the higher ROE for the distribution segment and not transmission.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating North American Energy Utilities (Electric, Natural Gas and Pipelines), which can be found on our website under Methodologies.