DBRS Confirms Issuer Rating and Debt Ratings of Hydro One Inc. Downgrades Commercial Paper Rating

DBRS Limited (DBRS) has today confirmed the Issuer Rating and the Senior Unsecured Debentures rating of Hydro One Inc. (HOI or the Company) at A (high) and has downgraded HOI’s Commercial Paper (CP) rating to R-1 (low) from R-1 (middle). All ratings have Stable trends. This rating action removes the Issuer Rating and Senior Unsecured Debentures ratings from Under Review with Developing Implications and the CP ratings from Under Review with Negative Implications where they were placed on September 18, 2015. Please refer to the DBRS press release, “DBRS Places Issuer and Debt Ratings of Hydro One Inc. Under Review with Developing Implications and Commercial Paper Ratings Under Review with Negative Implications.”

The current rating action is consistent with DBRS’s expectations as noted in the September 18, 2015, press release and follows today’s closing of the initial public offering (IPO) of common shares of Hydro One Limited (HOL) offered by the Province of Ontario (the Province, rated AA (low) by DBRS). DBRS has reviewed the Supplemented PREP Prospectus (the Prospectus) as filed on October 29, 2015, and also notes that certain pre-closing transactions involving the capital structure of HOI have been completed prior to the closing of the offering. These include (1) HOL’s acquisition of all the issued and outstanding shares of HOI. from the Province; (2) HOI has executed a credit agreement dated October 30, 2015 in order to provide for a new three-year senior unsecured revolving term credit facility in the amount of $800 million; (3) HOI has also increased the authorized amount of short-term notes that it can issue under its CP program from $1.0 billion to $1.5 billion; and (4) HOI’s regulated subsidiary, Hydro One Networks Inc. (HONI) has been recapitalized at its regulated capital structure of 60.0% debt to rate base (55.5% at June 30, 2015) through incremental borrowing to pay a dividend of $800 million to the Province. The dividend amount was revised from the $1.0 billion previously disclosed by HOI, reflecting a revised estimate of approximately $200 million in additional payments in lieu of taxes (PILs) that are expected to be payable by HOI to the Ontario Electricity Financial Corporation by the end of 2015. The PILs are in addition to the $2.6 billion departure tax paid by HOI in respect to the deemed disposition of its assets as a consequence of the IPO on November 4, 2015. The Province, as shareholder, had concurrently subscribed for additional common shares of HOL for an aggregate subscription price of $2.6 billion, to pay the departure tax.

Based on its review, DBRS continues to view the IPO as having a minimal impact on the business risk profile of HOI’s regulated utility business. HOI’s low-risk business profile continues to be supported by a reasonable regulatory framework in Ontario and by operations in an extensive franchise area with a steady growth in customers. The Company operates approximately 97% of the Province’s electricity transmission network, is connected to 46 local distribution companies and 90 transmission connected companies, and serves approximately five million customers. The Company’s regulated transmission and distribution businesses in Ontario, which accounts for substantially all its earnings, (approximately, 63% and 37% of last 12 months to June 30, 2015, EBIT, respectively) operates under a cost of service framework, which provides certainty for recovery of operating and capital costs as it reduces regulatory lag and forecasting risk.

From a financial risk perspective, DBRS expects a mix of factors to weaken the Company’s financial profile: (1) HOI has increased debt levels resulting from the recapitalization of HONI to reach its regulatory capital structure of 60% of debt to rate base, with the increased borrowings used to pay a $800 million dividend to the Province; (2) DBRS expects HOI to support HOL’s dividend policy, to pay approximately 70% to 80% of the latter’s consolidated net income as dividends, to the extent that such dividend payouts maintain HONI’s regulatory capital structure. Consequently, DBRS expects HOI to pay a higher portion of its earnings as dividends going forward; and (3) HOI is currently in the midst of an aggressive build-out program that will continue over the next several years, and combined with the higher dividends is expected to continue generating free cash flow deficits which will cause the Company to have a greater reliance on borrowings. Although post-IPO, HOI will have indirect access to equity markets through its parent HOL, higher borrowings will pressure the Company’s balance sheet and coverage ratios.

DBRS expects the impact of HOI’s weaker financial risk profile to be mitigated by its relatively strong business risk profile providing support to the current A (high) Issuer and Senior Unsecured Debentures rating. However, as HOI plans to maintain a higher debt level and have a greater reliance on short-term borrowings than historically, HOI’s CP rating no longer meets the requirements of the “DBRS Criteria: Commercial Paper Liquidity Support for Non-Bank Issuers” for a rating exception of R-1 (middle). DBRS has therefore downgraded HOI’s CP rating by one notch to R-1 (low).

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodologies are Rating Companies in the Regulated Electric, Natural Gas and Water Utilities Industry and DBRS Criteria: Commercial Paper Liquidity Support for Non-Bank Issuers, which can be found on the DBRS website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

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