DBRS Confirms Union Gas Limited at “A” and R-1 (low), Stable

DBRS has today confirmed the ratings of the Unsecured Debentures/Medium-Term Note Debentures, the Commercial Paper and the Cumulative Redeemable Preferred Shares of Union Gas Limited (Union or the Company) at “A,” R-1 (low) and Pfd-2, respectively, all with Stable trends. The confirmations reflect relatively stable earnings contributions from Union’s regulated businesses (i.e., gas distributions, regulated storage and gas transmission), which accounted for the majority of consolidated earnings, and Union’s reasonable credit profile.

Union’s financial performance continued to benefit from the ongoing expansion of higher-margin non-regulated natural gas storage facilities, offset by higher cost-cutting (as a result of Union’s regulatory regime having changed from a cost-of-service (COS) system to an incentive regulation (IR) framework in 2008). However, DBRS is concerned about rising non-regulated business exposure, affecting Union’s overall business risk profile and increasing earnings volatility. Non-regulated earnings increased from 10% in 2008 to approximately 15% to date (DBRS estimate) and are expected to continue to rise over the medium term. DBRS views the Company’s 65.1% debt level in the capital structure as rather high, but manageable, given its rising non-regulated business exposure. DBRS notes that the Company has filed a rate case for the 2013 rebasing, asking for a 40% deemed equity (currently 36%) and higher return on equity (currently 8.54%). If its request is granted, DBRS expects Union to manage its balance sheet in-line with the new regulatory capital structure and maintain greater financial flexibility.

The IR framework creates uncertainty in the regulated business that did not exist under the COS system. Earnings from the regulated distribution business are under cost-saving pressure with the IR framework. Union is required to continue to identify cost-saving opportunities to overcome the productivity factor of 1.82% to improve its earnings. Cash flow deficits are expected over the medium term due to higher capex for storage expansion and gas transmission projects. DBRS expects the Company to finance the deficits through managing dividends and issuing new debt in a prudent manner to maintain its debt-to-capital within DBRS’s “A” rating range.

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

The applicable methodology is Rating Companies in the North American Energy Utilities (Electric and Gas) Industry (May 2011), which can be found on the DBRS website under Methodologies.