DBRS Changes Trends on TransAlta and Capital Power

DBRS Limited (DBRS) has today changed the trends of all long-term debt ratings of Capital Power Corporation, Capital Power L.P. and TransAlta Corporation (collectively, the IPPs) to Negative from Stable. DBRS has also changed the trend of TransAlta Corporation’s preferred share rating to Negative from Stable. The rating actions reflect DBRS’s concern that the continued challenging wholesale power market environment and heightened political risk in Alberta may lead the IPPs’ credit risk profile to deteriorate to a level that is no longer consistent with their respective rating categories. The rating actions at this time are limited to trend changes with no immediate rating downgrades, as the negative factors that could lead to downward rating pressure are over the medium to long term. DBRS does not anticipate any material weakness in the IPPs’ financial profile in 2016 from 2015, largely because of strong hedging support and manageable capital spending, despite lower power prices in Alberta.

DBRS has also confirmed the preferred share rating of Capital Power Corporation at Pfd-3 (low) with a Stable trend. This reflects DBRS’s belief that the existing preferred share rating is already conservative given that Capital Power Corporation’s Senior Unsecured Debt is now guaranteed by Capital Power L.P. following the recent medium-term note exchange. DBRS views it as unlikely that any debt instruments will be issued at Capital Power L.P. going forward, mitigating structural subordination risk.

DBRS believes the continued weak operating environment and the effect of Alberta Climate Leadership Plan (ACLP) combined will gradually weaken several primary business risk profile factors for the IPPs, including (a) hedging profile, particularly post-2020, as all long-term Alberta power purchase arrangements (PPAs) expire by 2020; (b) market position; and (c) market structure and environment. A weakening business risk profile will likely result in a one-notch downgrade to BBB (low) from BBB for the IPPs. A multi-notch downgrade below investment grade is unlikely in the foreseeable future, unless the implementation of the ACLP would materially affect the IPPs’ financial flexibility and profitability.

Challenging Market Structure and Environment
A recovery of the wholesale power market fundamentals is expected to take longer than DBRS originally anticipated when DBRS confirmed the IPPs’ ratings in March 2015. The outlook for the deregulated Alberta power market remains negative, given the continued overcapacity headwinds coupled with sluggish demand growth (refer to “DBRS Comments on the Outlook for the Alberta Power Market: Bearish Outlook Remains as Fundamentals Weaken,” dated January 19, 2016). Furthermore, political risk within the Province of Alberta (the Province) has increased as it remains unclear how (1) coal-fired generators will be compensated for stranded coal assets under the ACLP and (2) what portion of coal compliance costs will be recovered through higher power prices. While forward prices beyond 2018 are currently higher by $10 to $20 per megawatt hour than the 2016 forward price (reflecting higher variable costs that will be bid into the wholesale market to offset at least some of the higher carbon price), trading liquidity is very limited.

With transitioning away from coal to renewable energy, DBRS expects the IPPs to invest in new power project opportunities, particularly wind farm and natural gas power projects. As a result, another key challenge for the IPPs is executing power project development strategies in the weak price environment, which could constrain liquidity, profitability and leverage. As noted in the commentary “DBRS Comments on the Effect of New Alberta Power Projects on Key Credit Metrics,” dated February 11, 2016, new wind and natural gas power projects would require substantially higher wholesale power prices than current 12-month forward prices to minimize negative financial impacts on a BBB-rated IPP. Based on DBRS’s analysis, new natural gas power projects would require an average realized pool price of $80/megawatt-hour (MWh), while wind power projects would need a benchmark pool price (before wind discounts) of $80/MWh and renewable energy credits (RECs, or equivalent subsidies) of $40/MWh to commensurate with the BBB rating range. The 12-month average forward price is currently depressed, at around $30/MWh. The key credit metrics for the BBB rating category are as follows: (a) 15% to 35% for the cash flow-to-debt ratio, (b) 4.0 times (x) to 7.0x for the EBITDA-to-interest coverage ratio and (c) 30% to 50% for the debt-to-capital ratio. It is important to note that actual plant results could depart materially from our analysis, largely due to the deviation between the assumptions underlying our model and actual plant performance and capital structure.

Market Position
The generation market in Alberta is heavily concentrated, with five main players controlling approximately 67% of the generating capacity in Alberta. These include Capital Power Corporation, TransAlta Corporation, ENMAX Corporation (rated A (low), ATCO Ltd. (rated A (low) and TransCanada Corporation (Preferred Shares rated Pfd-2 (low)). DBRS believes it is currently very challenging for new entrants to develop a strong market position, largely because of: (1) the capital-intensive nature of the industry, (2) Alberta’s relatively small market size with limited intertie connections and (3) a portfolio bidding approach for dispatching that favours the incumbent power producers with well-diversified generation fuel mix (base load, intermediate, and peaking facilities). However, the government’s plan to move away from coal and toward clean power could encourage new players with lower cost of capital, increasing competitive pressures for the IPPs.

Strong Contractual and Hedged Output for 2016–2020 period
A strong contractual and hedged output position currently limits the IPPs’ exposure to the volatile wholesale pricing environment over the next five years. Following the deregulation of the generation market, long-term power purchased agreements were auctioned in 2000 for generation plants built under the previous regulatory system. The long-term purchase agreements were effective on January 1, 2001, and are scheduled to expire by 2020. If new long-term purchase agreements or hedges are not properly executed, the IPP’s exposure to the volatile merchant pricing environment will increase materially. With their aging coal plants closer to retirement, the IPPs will likely face challenges to effectively hedge future generation output because of a potential increase in plant outages.

Impact on Capital Power Corporation and Capital Power L.P. (collectively, Capital Power) – Negative
Capital Power is the most exposed to the Alberta power market among DBRS-rated issuers, as 79% of net generation capacity is located in the Province. Furthermore, Capital Power’s coal fleet on average is much younger than its peers, facing greater uncertainty associated with stranded asset cost recovery. However, Capital Power’s financial risk profile is supportive of the current rating category, with all key credit metrics in the BBB range, and is expected to remain within the range in 2016.

Impact on TransAlta Corporation (TransAlta) – Negative
While TransAlta is less affected by the Alberta climate change strategy than Capital Power, the phase-out of all coal plants by 2030 and rising carbon compliance costs also have potential negative rating implications for TransAlta. Furthermore, TransAlta’s key credit metrics have remained relatively constrained for the current rating, which provides TransAlta with very limited financial flexibility. DBRS acknowledges that TransAlta has responded to the weak power pricing environment by cutting dividends and implementing cost-saving measures.

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.

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

The applicable methodologies are Rating Companies in the Independent Power Producer Industry, DBRS Criteria: Guarantees and Other Forms of Explicit Support, DBRS Criteria: Rating Holding Companies and Their Subsidiaries and DBRS Criteria: Preferred Share and Hybrid Criteria for Corporate Issuers, which can be found on our website under Methodologies.

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