Morningstar DBRS Confirms Ratings on Arrow Lakes Power Corporation at A (high), Stable Trends

DBRS Limited (Morningstar DBRS) confirmed the Issuer Rating on Arrow Lakes Power Corporation (ALPC or the Company) and the rating on the Company’s Series B Bonds (the Bonds) at A (high) with Stable trends. The 5.516% $350 million Bonds will be fully amortized by the maturity date of April 5, 2041, four years before the expiry of the Electricity Purchase Agreement (EPA).

ALPC is a single-purpose entity that owns and operates a 185-megawatt hydroelectric power station and associated transmission line (the Project). The Company is a tax-exempt Crown corporation indirectly owned by the Province of British Columbia (the Province; rated AA (high) with a Stable trend).

KEY CREDIT RATING CONSIDERATIONS
The ratings confirmation stems from Morningstar DBRS’s view that the Company’s DSCR is expected to remain above the projected minimum debt service coverage ratio (DSCR) of 1.84 times (x) in F2025 (year ended March 31) despite the planned shutdown of the Unit 2 Generator (Unit 2) that began in February 2024 and is expected to last for six months. The planned shutdown of Unit 2 is related to the unplanned major outage of the Unit 1 Generator (Unit 1) in 2023 that lasted for more than 10 months. The Unit 1 repair work was completed in September 2023 and the reassembling of the unit was completed in February 2024.

Even though the Unit 1 repair cost and the loss of revenue were largely covered by the insurance proceeds, the Company’s DSCR in F2024 is still expected to drop to 1.70x from 2.18x in F2023 because it is expected to incur significant liquidated damages of about $13 million. Morningstar DBRS also notes that dividend distributions were suspended in F2024 as the owners were supporting (provided equity injection to mitigate any liquidity shortfall) the Company throughout the Unit 1 outage period. Dividend distribution is projected to be about $43 million in F2025.

The Independent Engineer (IE) determined that the failure of Unit 1 was caused by the failure of several piston head studs. After further analysis, the mechanical properties of the failed piston head studs may have been compromised by the higher-than-expected heating temperature during the installation process. In addition, the exposure to different rates of cooling may have also contributed to the reduction in the expected life of the failed piston head studs.

As a result, the Company has decided to replace the piston head studs in Unit 2 to mitigate any potential future unplanned outages related to the Unit 1 outage. Morningstar DBRS notes that the shutdown of the Unit 2 is a priority for the Company because the loss of revenue could be substantial if it delays the start of repair of Unit 2 until the second half of 2024. That is because the loss of revenue for an outage of one unit during July 2024-December 2024 period is projected to be around $27 million. This is significantly more than the 2024—25 budgeted allowance for planned outages of about $5.4 million based on the projected repair schedule of six months starting from February 2024 and completing by July 2024. Furthermore, the planned outage of Unit 2 will not incur any liquidated damages.

The Company indicated that the Unit 2 repair cost is expected to be about $3.7 million or about 40% lower than the Unit 1 repair cost. According to the Company, the lower Unit 2 repair cost is due to significantly less resources for project planning, engineering, and preparation work as this work was largely completed during the repair of Unit 1. In addition, the Unit 1 repair cost included other clean-up cost of about $0.4 million and there are some materials procured for Unit 1 that were not required (i.e., new piston head). Morningstar DBRS notes that about $1 million of the total $3.7 million is projected to be spent in F2024. Therefore, the Company will incur the remaining cost of about $2.7 million in F2025.

Based on the Company’s forecast, the capital expenditure (capex) in F2024 is projected to be about $2.3 million, which is about 15% lower than budget. The lower-than-expected spending is due to the reallocation of resources to the Unit 1 repair. One of the major capital works that was delayed is the digital governor excitation controls upgrade. In the Company’s F2025 budget, the Company is expected to complete one unit in April 2024 with the subsequent unit to be completed in April 2025. Moreover, the Company will continue with other multiyear capital projects such as the intake gate cylinder rebuilds and dewatering controls upgrade. In total, F2025 capital budget is expected to amount to about $3.6 million (an increase of $0.3 million over F2024).

Capex in F2026 is projected to rise to $3.9 million, including multiyear projects such as the digital governor excitation controls upgrade and intake gate 4 and 6 refurbishments that are projected to account nearly 50% of the total capital budget. After F2026, capex is forecast to decline to $1.5 million.

CREDIT RATING DRIVERS
A positive credit rating action is unlikely because the current ratings are constrained by the projected minimum DSCR of 1.84x. Morningstar DBRS may take a negative credit rating action if the Company’s DSCR declines significantly below expectations as a result of a material delay and/or significant cost overrun in connection with the Unit 2 Generator repair. In addition, a negative credit rating action may occur if there are other major operating failures causing unexpected high outages and/or materially higher nonroutine maintenance cost than budgeted.

FINANCIAL OUTLOOK
Based on the Company’s F2025 budget, DSCR is expected to increase to 1.98x from a projected DSCR of 1.7x in F2024. Under Morningstar DBRS’s base case scenario after incorporating the Company’s most recent capital budget and forecast, the Company’s DSCR is projected to rise to 2.10x in F2026.

CREDIT RATING RATIONALE
The credit ratings reflect the Project’s highly predictable cash flow and DSCR, underpinned by (1) the Keenleyside Entitlement Agreement (the Entitlement Agreement) and the Electricity Purchase Agreement (EPA), essentially eliminating the hydrology and price risks; (2) reliable and low-cost characteristics of the underlying hydro assets; and (3) an aligned interest (e.g., BC Hydro is the counterparty for the Entitlement Agreement and the EPA and also indirectly owns the Company) of all participants in the Project. The ratings also consider the strong credit profile of British Columbia Hydro and Power Authority (BC Hydro; rated AA (high) with a Stable trend), which is the counterparty for the Entitlement Agreement and the EPA. The credit ratings are also subject to various challenges such as (1) an unfunded debt service reserve; (2) exposure to long-term operating and capex risk; and (3) additional pari passu debt, which can affect future credit ratings.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant 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 (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

RATING DRIVER AND FINANCIAL RISK ASSESSMENT (FRA)
A) Weighting of Rating Driver Factors
-- In the analysis of Arrow Lakes Power Corporation, the Rating Driver factors listed in the methodology are considered in the order of importance.

B) Weighting of FRA Factors
-- In the analysis of Arrow Lakes Power Corporation, the following FRA factor listed in the methodology was considered more important: DSCR (this is the only applicable factor).

C) Weighting of the Rating Driver and the FRA

In the analysis of Arrow Lakes Power Corporation, the FRA carries greater weight than the Rating Driver.

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

Morningstar DBRS applied the following principal methodology:

Global Methodology for Rating Project Finance (September 12, 2023)
https://dbrs.morningstar.com/research/420425/global-methodology-for-rating-project-finance

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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