Morningstar DBRS Downgrades Northwestern Hydro Acquisition Co II LP to BBB from BBB (high), Negative Trend

DBRS Limited (Morningstar DBRS) downgraded the Issuer Rating of Northwestern Hydro Acquisition Co II LP. (the Issuer) and the rating of its $546 million Senior Secured Bonds – Series 2036-1 and Senior Secured Bonds – Series 2036-2 to BBB from BBB (high). All trends remain Negative. The downgrade and Negative trend reflect Morningstar DBRS’ view that the project has yet to prove the ability to consistently perform at budgeted expectations, despite some signs of progress in this area.

The Issuer, is a Special-Purpose Vehicle owned by Axium Infrastructure and Manulife, the Project Sponsors, that owns 27.5% of Coastal Mountain Hydro Limited (CMH), the operating company. CMH holds three run-of-river hydro-generating facilities in northwestern British Columbia. The Projects Sponsors hold a total of 85% in the operating company collectively through ownership in Northwestern Hydro Acquisition Co Inc, with a 35% stake, and Northwestern Hydro Acquisition Co III LP, with a 27.5% ownership stake in the operating company.

KEY CREDIT RATING CONSIDERATIONS
The downgrade follows continued difficulty experienced by CMH in managing its operating costs, leading to consistently underperforming coverage ratios at the Issuer level. In 2022 and early 2023, the Project Sponsors engaged in a reset of the operating budget, structurally increasing its baseline operating cost estimate by almost $10 million dollars annually for the next five years and identifying a clear program of capital expenditures and other repairs and maintenance to address ongoing issues. As a result of the baseline cost reset, in 2023, Morningstar DBRS downgraded the Issuer’s credit ratings to BBB (high) from A (low) while maintaining a Negative trend. At the time, Morningstar DBRS noted that demonstrated ability to maintain the revised budget would be a key factor in rating stability.

Following this reset, cost control has exhibited some signs of improvement in 2023, as a key capital expenditure (capex) repair program came in under budget for the year, while a large part of the $3 million cost overrun was attributable to a conscious decision to increase the scope of planned repair and maintenance activity following an assessment of more adverse wear conditions than expected. This resulted in 19 steel plates being replaced with thicker steel compared to the originally planned 12 plates, avoiding the need for an outage in 2024 and negating the planned replacement of these remaining plates in 2025. However, revenue was adversely affected as the Project Sponsors were unable to maintain generation during the Q1 maintenance window, as was the original intent, and was forced instead to institute an unplanned outage for most of March, while anticipated ancillary revenues from an agreement with a mining company to build a direct interconnection line were delayed to 2024 until the required regulatory permits are obtained. On an accrual basis, Morningstar DBRS calculates the 2023 debt service coverage ratio (DSCR) to be 1.23 times (x) after netting out the effect of the Project Sponsors drawing on the credit facility, below the budgeted 1.31x forecasted last year and well below the level of the current rating.

Although Morningstar DBRS expects coverage ratios to gradually rise back to the originally forecasted 1.50x range by the latter half of the 2020s, DSCRs will remain stressed in the immediate future, reducing the ability of project to absorb negative developments, including continued further unplanned repair and maintenance expenditures despite the best efforts of the Sponsors (as seen in 2023), as well as a reversion in the hydrology cycle, which has been on the upswing since 2019, to a downswing similar to that experienced in 2018 and early 2019. On this basis, and on the basis of continued coverage ratio underperformance relative to budget projections, Morningstar DBRS is downgrading the Issuer’s credit ratings to BBB while maintaining the Negative trend.

CREDIT RATING DRIVERS
The possibility of material cost overrun in the budgeted operations and maintenance or capex costs underlies the Negative trend, and continued cost overruns will be credit negative. Morningstar DBRS notes that continued coverage ratios in the current range of less than 1.30x without clear progress in achieving budgeted costs could result in a multinotch downgrade.

FINANCIAL OUTLOOK
Morningstar DSCR’s rating case projection shows a forward minimum DSCR of 1.37x in 2024, rising to 1.50x by the latter half of the 2020s, based on budgeted costs. However, this projection is based on a P-50 hydrology level, and a downswing in the hydrology cycle or material cost overruns could lead to a lower achieved DSCR. Although the project nominally shows an increasing DSCR profile based on budgeted costs, the continuing historical cost overruns and low coverage ratios warrants a Negative trend until a clear track record of achieving budgeted costs is established.

CREDIT RATING RATIONALE
The credit rating is predicated on the following attributes: (1) 60-year fixed price Electricity Purchase Agreements (EPAs), fully indexed to British Columbia inflation, with highly rated BC Hydro; (2) comparatively new assets with a long remaining asset life and proven technology; and (3) favourable debt package with bondholders. The rating is also subject to the following constraints and weaknesses: (1) operating and capital expenditure cost uncertainty, particularly as experienced over the past few years; (2) hydrology and generation uncertainty inherent in a run of river project; (3) potential for dilution of ownership stake from exercise options granted to the Tahltan Central Council (TCC); 4) refinancing risk.

TRANSACTION-SPECIFIC DISCLOSURES
Morningstar DBRS’s calculated DSCR for 2023 nets out the uplift from a credit facility draw at the operating company level used to cover the increased cost from the expanded maintenance scope and the delay in receipt of ancillary revenue.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (January 23, 2024).

BUSINESS RISK ASSESSMENT (BRA) AND FINANCIAL RISK ASSESSMENT (FRA)

A) Weighting of BRA Factors
-- In the analysis of Northwestern Hydro Acquisition Co II LP, the Rating Driver factors listed in the methodology are considered in the order of importance.

B) Weighting of FRA Factors
-- In the analysis of Northwestern Hydro Acquisition Co II LP, the following FRA factor listed in the methodology was considered more important: DSCR (this is the only applicable factor).

C) Weighting of the BRA and the FRA
-- In the analysis of Northwestern Hydro Acquisition Co II LP, the FRA carries greater weight than the BRA.

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

Morningstar DBRS applied the following principal methodology(ies):
-- Global Methodology for Rating Project Finance (September 12, 2023); https://dbrs.morningstar.com/research/420425/global-methodology-for-rating-project-finance

The following methodologies have also been applied:
-- Morningstar DBRS Criteria: Approach to Environmental, Social and Governance Risk Factors in Credit Ratings (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings

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

A description of how Morningstar DBRS analyzes corporate finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.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 info-DBRS@morningstar.com.

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.

Morningstar DBRS 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. Morningstar DBRS trends and credit ratings are under regular surveillance.

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

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