DBRS Morningstar Confirms Hydro Ottawa Holding Inc. at A (low), Changes Trend to Negative from Stable

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating and Senior Unsecured Debt rating of Hydro Ottawa Holding Inc. (Hydro Ottawa or the Company) at A (low) and changed the trends on the ratings to Negative from Stable. Concurrently, DBRS Morningstar confirmed the rating of Hydro Ottawa's Commercial Paper program at R-1 (low) and changed the trend on the rating to Negative from Stable. The rating confirmations reflect the continued strength and stability of Hydro Ottawa’s regulated electricity distribution operations. The Negative trends reflect DBRS Morningstar's concern that Hydro Ottawa's current and projected growth from unregulated businesses will continue to outpace growth from its regulated business, which could further deteriorate its business risk profile.

In 2020, DBRS Morningstar had downgraded Hydro Ottawa's ratings to A (low) from "A" because the sustained increase in EBIT contribution from the unregulated electricity generation business rose above the previous 20% threshold, as DBRS Morningstar considers Hydro Ottawa’s unregulated business, even with presence of long-term contracts, as higher risk than its core regulated electricity distribution business. Since then, the proportion of unregulated businesses in the earnings mix has continued to increase materially, with the unregulated business consistently contributing around 35% of consolidated EBIT and reaching close to 40% in 2022. The negative rating actions reflect the developments over the medium term, including the growth in the unregulated business, which materially surpassed DBRS Morningstar's previous expectation that this business would be limited to 30% to 35% of consolidated EBIT. DBRS Morningstar may change the trend to Stable if EBIT contribution by the unregulated business decreases and remains below 35% on a sustained basis, while a rating downgrade is likely if contributions remain at or above 35%.

Hydro Ottawa’s overall business risk profile continues to benefit from Hydro Ottawa Limited (HOL), which is a stable regulated electricity distributor in the City of Ottawa (100% owner of Hydro Ottawa). HOL is regulated by the Ontario Energy Board and sets its rates under the Custom incentive rate (IR) method, which is a hybrid of cost of service (COS) and the IR-setting method (IRM), for a five-year period from 2021 to 2025. The business risk is increased by its growing portfolio of unregulated electricity generation assets at Energy Ottawa Inc (EOI) and an expanding energy services business including Envari, Hydro Ottawa’s energy services division, and the recently launched Hiboo Networks Inc., a wholesale telecommunications optical fibre business. The electricity generation portfolio is largely supported by annually escalated fixed-price power purchase agreements with approximately 83% of capacity contracted with the Independent Electricity System Operator (IESO), but DBRS Morningstar notes this business segment does involve higher volume and operational risk, leading to more volatile earnings and cash flows. Given Hydro Ottawa's forecast growth, DBRS Morningstar now expects the unregulated business to contribute around 35% to 40% of consolidated EBIT over the short to medium term, with the remainder coming from the regulated business.

Hydro Ottawa’s financial metrics remained stable in 2022 and weakened modestly in the last 12 months ended June 30, 2023, reflecting higher borrowing costs and weaker performance of the generation facilities. DBRS Morningstar notes Hydro Ottawa has relatively weaker consolidated financial metrics compared with its utility peers, reflecting higher levels of leverage associated with the electricity generating assets. DBRS Morningstar will monitor the increasing mix of unregulated revenue from all sources in its assessment of Hydro Ottawa’s business fundamentals. Maintaining the share of EBIT from unregulated business at current levels will likely result in a one-notch downgrade to current ratings. Further negative rating actions, which DBRS Morningstar deems unlikely, may occur should Hydro Ottawa’s key credit metrics deteriorate to a level no longer commensurate with the current rating category, even if unregulated EBIT contribution is maintained at the current level. Conversely, the trend can return to Stable if, assuming market conditions remain normal, contributions from the unregulated segment stays below 35%. A ratings upgrade is unlikely in the foreseeable future, unless Hydro Ottawa materially reduces its exposure to the unregulated business.

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/416784 (July 4, 2023).

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

DBRS Morningstar applied the following principal methodologies:

-- Global Methodology for Rating Companies in the Regulated Electric, Natural Gas, and Water Utilities Industry (September 13, 2022; https://www.dbrsmorningstar.com/research/402616).

-- Global Methodology for Rating Companies in the Independent Power Producer Industry (May 9, 2023; https://www.dbrsmorningstar.com/research/413646).

-- DBRS Morningstar Global Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (October 26, 2022; https://www.dbrsmorningstar.com/research/404334).

-- DBRS Morningstar Global Criteria: Commercial Paper Liquidity Support for Nonbank Issuers (February 24, 2023; https://www.dbrsmorningstar.com/research/410196).

The credit 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.

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 credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

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

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