DBRS Morningstar Places H2O Power Limited Partnership and Watergen Canada Holdings Inc. Under Review with Negative Implications

DBRS Limited (DBRS Morningstar) placed the Issuer Rating and the Senior Secured Bonds (the Bonds) rating of H2O Power Limited Partnership (H2O) and Watergen Canada Holdings Inc. (Watergen; together with H2O, the Issuers or Co-Borrowers) Under Review with Negative Implications. The Issuers own and operate eight hydroelectric power generation facilities (the Facilities) with a total capacity of approximately 151 megawatts in Ontario and sell virtually all the electricity generated to the Independent Electricity System Operator (IESO). At this time, DBRS Morningstar does not consider the current credit profile of IESO as constraining either the Issuer Rating or the Bonds rating. The Facilities have a 20-year contract (approximately 7.5 years remaining) for existing hydroelectric generation facilities with the IESO (the IESO Contract) through November 2029. The Facilities have been in operation since the early 1900s. The $460.05 million Bonds are partially amortizing during the term of the IESO Contract with a balloon repayment of 20% ($92.01 million) at bond maturity in November 2029.

The ratings remain supported by (1) the strength of the 20-year fixed-price IESO Contract with a highly rated offtaker, (2) a strong operating history and hydrology record, and (3) an experienced owner and operations team. The ratings are constrained by (1) hydrology risk, (2) refinancing risk, and (3) capital expenditure (capex) and operations and maintenance (O&M) risks.

DBRS Morningstar placed the ratings Under Review with Negative Implications because of the potential for a breach of a financial covenant under the financing documents, considered an event of default (EOD), as the Issuer may fail to maintain a debt service coverage ratio (DSCR) of at least 1.0 times (x), which is calculated quarterly (in the periods ending February, May, August, and November) based on last 12 month (LTM) financial results, for the period ending May 31, 2022, and/or August 31, 2022, as well as possibly for the period ending November 30, 2022 or beyond. DBRS Morningstar notes that the lenders have provided an irrevocable waiver for the anticipated default for the periods ending May 31, 2022, and August 31, 2022; however, the waiver does not apply to the period ending November 30, 2022, or beyond, which leaves uncertainty that an EOD could occur as the projected DSCRs are dependent on hydrology, and the assumption that no operational issues will occur, etc. The potential anticipated default is due to a combination of (1) extremely low DSCRs in 2021 that are affecting 2022 DSCR levels as the DSCR calculations for period ending May 31, 2022, and/or August 31, 2022, are LTM based and (2) the planned replacement of two transformers, which is presently underway and will be delivered in Q3 2022. The Under Review with Negative Implications could be resolved when DBRS Morningstar deems that there is no risk of breach of the DSCR financial covenant for the period ending November 30, 2022, or beyond. DBRS Morningstar will continue to closely monitor the project and may consider an adverse rating action if the project experiences a sustained increase in capex and O&M expenses, reduced availability (higher forced outages) with material impacts on the DSCR, and increased refinancing risk.

For 2021, the DSCR of 1.19x was very low because of extremely poor hydrology across all eight facilities. The overall generation was 648.8 gigawatt hours (GWh) which was approximately 14% and 24% lower than P90 (approximately 756.5 GWh) and P50 (approximately 857 GWh) projections, respectively. This is the second straight year in which the hydrology has been low; in 2020, the generation loss related to low hydrology was approximately 10% from P50 levels. DBRS Morningstar notes that the 2020 reported DSCR is changed to 1.30x from 1.43x. The reason for the change is recognition of an insurance settlement of $4.88 million that was included in 2020 DSCR calculations; however, this is now being captured in the 2021 DSCR calculations. For Q1 2022, the hydrology has normalized and the generation for the full year (FY) 2022 is expected to be close to P50 levels. The DSCR for FY2022 is expected to be around 1.40x. DBRS Morningstar notes that this is the third straight year in which the DSCRs would be much lower than projections of 1.65x. In 2023, the DSCR is projected to be lower as well at around 1.50x because of higher than planned capex of around $9 million. DBRS Morningstar expects the long-term DSCR projection to continue to be around 1.65x, which is consistent with the assigned ratings. In addition, there is no change in DBRS Morningstar's assessment of the refinancing risk at this time.

DBRS Morningstar may take a positive rating action if the financial performance is materially better than projections on a consistent basis and the refinancing risk is mitigated.

There were no environmental, social, or governance (ESG) factors that had a significant or relevant effect on the credit analysis. A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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

The principal methodology is Rating Project Finance (August 18, 2021), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings).

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 [email protected].]

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

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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