DBRS Confirms Ratings of Hydro One Inc. at A (high)/R-1 (low), Stable Trends

DBRS Limited (DBRS) confirmed the Issuer Rating and the Senior Unsecured Debentures rating of Hydro One Inc. (HOI or the Company) at A (high) and the Commercial Paper rating at R-1 (low). All trends are Stable. The rating confirmations reflect the Company’s relatively low risk business profile supported by a transparent regulatory framework, a strong franchise area for its electricity transmission and distribution services and a reasonable financial profile sustained by predictable earnings and cash flow. The Stable trends assume that the regulatory regime will continue to remain supportive, allowing the Company to earn a fair rate of return while recovering costs on a timely basis.

HOI is the largest electricity transmission and distribution company in the Province of Ontario (the Province; rated AA (low) with a Stable trend by DBRS). The Company is wholly owned by Hydro One Limited (HOL), which is in turn approximately 47.4% owned by the Province. The Company’s transmission business (approximately 63% of 2018 earnings before interest and tax (EBIT)) owns and operates approximately 98% of the transmission network in the Province while the distribution business (approximately 37% of 2018 EBIT) serves nearly 26% of the Province’s customers. HOI’s rate base has been growing consistently and reached $19.7 billion at the end of 2018.

DBRS rates HOI without assuming any credit support from its owner. HOI continues to be HOL’s only major asset. HOL and Avista Corporation, a regulated utility operating in the U.S. Pacific Northwest, terminated their 2017 merger agreement in January 2019. The decision followed denial of the merger by the public utility commissions of Washington and Idaho, citing political interference from the Province. DBRS notes that the termination of the merger does not have an impact on the credit profile of HOI and expects the Company to be internally focused on its existing footprint in Ontario. However, should political interference adversely affect the Ontario Energy Board’s (OEB) independent regulatory rate making framework or HOI’s operating and financial decisions, DBRS could take a negative rating action.

HOI’s distribution business operates under a performance-based Custom Incentive Rate-Setting (CIR) framework approved by the OEB for 2018-2022. The Company’s transmission business operates under an inflation-adjusted cost of service (COS) model for 2019 and filed a three-year (2020-2022) CIR rate application with the OEB on March 21, 2019. In a performance-based rate (PBR) making model, the OEB-approved electricity rates permit HOI to recover prudently-incurred costs and earn an allowed rate of return (9.0% for 2018) on its 40% deemed equity capital. PBR assumes that a utility becomes more efficient over time and ensures that increases to operating costs included in electricity rates are set below the level of inflation. Rates are adjusted formulaically, based on inflation and expectations regarding HOI’s productivity, in years subsequent to the initial rebasing of costs. HOI can retain some or all the savings and earn more than its allowed return on equity if it is able to achieve cost savings in excess of those approved by the OEB.

DBRS notes that HOI’s credit metrics continue to be pressured because of the incremental debt used to fund free cash flow deficits resulting from high capital expenditures (capex) and dividends. HOI’s $10 billion capex program for 2019-2023 (transmission: $6.3 billion; distribution: $3.7 billion) is largely to sustain aging power systems. Approximately 70% of HOI’s 2018 capex of $1.6 billion was spent on sustaining capex. HOI’s dividend payout ratio is expected to remain high in order to meet HOL’s dividend objective to pay out approximately 70% to 80% of its consolidated net income. HOI’s credit metrics face further pressure from the annual reduction of approximately $60 million in cash flow resulting from the OEB’s decision that the tax savings from the deferred tax asset resulting from the Company’s transition to a public company should be shared with rate payers ($885 million deferred tax asset write-off in 2018). While an upgrade to the rating is unlikely, DBRS could downgrade HOI’s ratings should the Company’s cash flow-to-debt ratio weaken below 13% and/or its DBRS adjusted debt-to-capital ratio exceed 60% on a sustained basis.

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

The principal methodologies are Rating Companies in the Regulated Electric, Natural Gas and Water Utilities Industry (September 2018) and DBRS Criteria: Commercial Paper Liquidity Support for Non-Bank Issuers (March 2019), which can be found on dbrs.com under Methodologies & Criteria.

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 under Related Documents or by contacting us at info@dbrs.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

DBRS will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving this report, contact us at info@dbrs.com.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.

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