DBRS Morningstar Downgrades Northwestern Hydro Acquisition Co III LP to BBB (high) from A (low), Maintains Negative Trends

DBRS Limited (DBRS Morningstar) downgraded Northwestern Hydro Acquisition Co III LP’s (the Issuer) Issuer Rating, Senior Secured Bonds – Series 2038-1, and Senior Secured Bonds – Series 2038-2 to BBB (high) from A (low) and maintained the Negative trends on the ratings. The Issuer is a nontaxable limited partnership owned by Manulife Financial Corporation (rated A (high) with a Stable trend by DBRS Morningstar), Axium Infrastructure Canada II LP, and the Tahltan First Nation. The Issuer holds a 27.5% stake in Northwest Hydro LP, which in turn owns Coast Mountain Hydro Limited Partnership (CMHLP or ProjectCo). CMHLP is a special-purpose vehicle that owns and operates three run-of-river hydro facilities in northwest British Columbia (the Province of British Columbia is rated AA (high) with a Stable trend by DBRS Morningstar). ProjectCo has been selling electricity to British Columbia Hydro and Power Authority (rated AA (high) with a Stable trend by DBRS Morningstar) under three separate 60-year Energy Purchase Agreements (EPAs) since 2014. The EPAs feature fixed energy pricing, which is indexed to British Columbia’s consumer price index for the entire contract term.

The rating downgrades stem from (1) consistent underperformance of the debt service coverage ratio (DSCR) below the level required for the A (low) rating category, due in large part to repeated general cost overruns from operational issues as well as unanticipated repairs from high water events and other incidents in the years immediately following the financing; and (2) structural and likely long-term increases in operating expenditure projections going forward, particularly with respect to labour costs and repair/maintenance costs. Ongoing multiyear repair projects to address the aforementioned incidents as well as to increase generation and operating efficiency exacerbate the higher cost projections. DBRS Morningstar notes that absent the short-term expenditures associated with these projects, which DBRS Morningstar does not view as structural costs, coverage ratios would be materially higher in 2023; however, the long-term increases in operating cost expenditures, which were revised after an extensive review, will push DSCRs below the A (low) rating range until 2027–28.

Water flows largely met or slightly exceeded P-50 levels in 2022 as river system hydrology appears to remain in the upswing portion of the hydrology cycle. Generation and revenue were adversely by significant ice buildup over the winter months, offset to some degree by generation in early spring (February, March, and April) above the theoretical maximum because of new low-flow runners, which improve generating efficiency during low water periods. After accounting for offtaker curtailments over the summer months, ProjectCo’s achieved productivity (or actual generation as a percentage of the theoretical maximum) was 96%, which is broadly consistent with DBRS Morningstar’s rating case expectations and a significant improvement over the 87% productivity factor in 2021 caused by icing in the winter and flooding in the summer. Revenue-wise, the project has benefitted from the high inflation of 6.6% in 2022 as the EPA offtake contract is inflation linked. DBRS Morningstar notes that this uplift will persist through the life of the contract. Upgrade projects undertaken over the next five years are expected to increase generation by another 41 gigawatts, or approximately 3%.

Total operating expenses for 2022 were above financing case projections by almost 40% due in significant part to the cost of repairs for damage caused by the flooding, adding to various one-time expense items, elevated labour costs, and ongoing multiyear expenditures required to address reinforcement requirements at the Forrest Kerr intake and for regulatory monitoring. As a result, achieved DSCR was 1.31 times (x), well below the rating range expectation of 1.50x. However, relative to the 2022 budget, total expenditures exceeded the forecast by only 3%, or approximately $2 million, which DBRS Morningstar views as indicative of ProjectCo gaining tighter control on unexpected costs. Accordingly, the achieved DSCR was close to DBRS Morningstar’s 2022 projection of 1.34x. Weighed down by a one-time expenditure of almost $10 million to complete the final stages of two multiyear repairs, DBRS Morningstar projects a DSCR of 1.31x in 2023 but notes that this rises to 1.42x absent the effects of this repair cost, which DBRS Morningstar continues to view as not structural in nature. However, the significant and permanent (or at least long-term) increase in forecast operating costs to the tune of almost $10 million is sufficient to keep projected DSCRs in the 1.40x range until at least 2027.

On the basis of this material increase to the project’s cost structure, DBRS Morningstar downgraded the ratings to BBB (high), notwithstanding the forecast return to DSCRs above 1.50x by 2027–28. Furthermore, DBRS Morningstar maintained the Negative trends and will closely monitor ProjectCo’s ability to maintain expenditures within the revised cost framework. A negative rating action is likely if costs continue to run over budget, while DBRS Morningstar could change the trends to Stable if ProjectCo proves capable of maintaining costs within budget. A positive rating action is not considered likely at this time.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance 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 (May 17, 2022).

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

The principal methodology applicable to the ratings is Global Methodology for Rating Project Finance (September 6, 2022; https://www.dbrsmorningstar.com/research/402400).

The rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

A description of how DBRS Morningstar analyzes corporate finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/397223/interplay-of-global-corporate-finance-rating-methodologies-when-analyzing-corporate-finance-transactions.

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.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com or contact us at [email protected].

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