Morningstar DBRS Discontinues Credit Ratings on Hydro Ottawa Holding Inc., Assigns New Credit Ratings of A (low) With Stable Trends to Hydro Ottawa Capital Corporation

DBRS Limited (Morningstar DBRS) discontinued all credit ratings of Hydro Ottawa Holding Inc. (HOHI) following the completion of the reorganization of HOHI on October 1, 2024. Morningstar DBRS concurrently assigned an Issuer Rating of A (low), a Senior Unsecured Debt credit rating of A (low), and a Commercial Paper program credit rating of R-1 (low), respectively, all with Stable trends, to Hydro Ottawa Capital Corporation (HOCC or the Company).

KEY CREDIT RATING CONSIDERATIONS
Morningstar DBRS notes as part of the reorganization, (1) HOHI transferred its interests in the regulated business, Hydro Ottawa Limited (HOL), and modest nonregulated ancillary businesses to HOCC; (2) HOCC assumed HOHI's obligations under the senior unsecured debentures, releasing HOHI from these obligations; (3) the operation of HOL remained unchanged as the reorganization does not involve the transfer of any rate order or license; and (4) the remaining nonregulated operations, including Energy Ottawa Inc.'s power generation business and its associated nonrecourse project-financed debt, will be transferred to another new subsidiary of HOHI, Hydro Ottawa Energy Services Inc., which is expected to close on January 2, 2025.

HOCC's business risk assessment is largely based on HOL, which accounts for the majority of HOCC's earnings. HOL is the regulated electricity distributor for Ottawa and operates under a reasonable regulatory environment overseen by the Ontario Energy Board (OEB). The regulated nature of HOL's operations will provide HOCC with predictable and steady cash flows, benefiting HOCC's credit metrics. HOL is under a Custom Incentive Rate-setting (IR) regime for a five-year period from 2021¿25 and is expected to file its 2026-2030 Custom IR application in early 2025.

HOCC's other business segments are unregulated, including Envari Holding Inc., an energy services business, and Hiboo Networks Inc., a business-to-business telecommunications optical fibre business. Morningstar DBRS is of the view that HOCC's unregulated operations, although riskier compared with its regulated operations, represent a small portion of HOCC's earnings and do not materially affect HOCC's overall credit quality.
Morningstar DBRS notes that there is no external debt at HOCC's subsidiaries, including HOL, and there is no intention of issuing debt at the subsidiary level. As such, there is no structural subordination in Morningstar DBRS' rating consideration.

CREDIT RATING DRIVERS
Morningstar DBRS is unlikely to take a positive credit rating action in the medium term given the stability of the current business risk profile and the elevated capital budget. A positive rating action could occur if the Company's credit metrics strengthen to the "A" rating range. A negative rating action may occur should the Company's key credit metrics weaken to a level no longer supportive of the current rating (i.e., cash flow-to-debt below 10.0%) for a sustained period.

EARNINGS OUTLOOK
On a pro forma basis, HOCC's earnings in 2023 were weaker than previous years, reflecting higher operating costs caused by severe weather events, inflationary pressure, elevated short-term interest rates, and a labor strike between June and September. Morningstar DBRS expects earnings to improve in 2024, reflecting higher approved rates and easing of inflationary pressure and borrowing costs. The Company's earnings are expected to improve after rebasing in 2026, supported by growth in the rate base from the significant capital expenditures (capex) program during the current cycle.

FINANCIAL OUTLOOK
On a pro forma basis, HOCC's credit metrics have been under pressure in recent years due to higher borrowing costs and significant capex in excess of cash flow generation. Capex is projected to stay elevated at approximately $140 million annually, net of customer contributions, for 2024 and 2025. This capex will primarily be directed towards HOL to improve system reliability and address increasing demographic demands. Given HOCC does not have access to public equity markets, the expected substantial free cash flow deficits will likely be debt-funded. Morningstar DBRS expects the Company's cash flow-to-debt will average approximately 10% in the medium term, reflecting higher earnings offset by higher leverage.

CREDIT RATING RATIONALE
HOCC's credit ratings are supported by the reasonable regulatory framework and reasonably resilient customer mix, dominated by residential and commercial customers (including the federal government). This is offset by balance sheet pressure from large capex program and no access to equity markets.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors 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 Factors in Credit Ratings (August 13, 2024) at https://dbrs.morningstar.com/research/437781.

BUSINESS RISK ASSESSMENT (BRA) AND FINANCIAL RISK ASSESSMENT (FRA)
(A) Weighting of BRA Factors
In the analysis of HOCC, the BRA factors were considered in the order of importance contemplated in the methodology.

(B) Weighting of FRA Factors
In the analysis of HOCC, the FRA factors were considered in the order of importance contemplated in the methodology.

(C) Weighting of the BRA and the FRA
In the analysis of HOCC, the BRA carries greater weight than the FRA.

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

Morningstar DBRS applied the following principal methodology:
-- Global Methodology for Rating Companies in the Regulated Utility and Independent Power Producer Industries (June 27, 2024), https://dbrs.morningstar.com/research/435127

Morningstar DBRS credit ratings may use of one or more sections of the Morningstar DBRS Global Corporate Criteria (April 15, 2024; https://dbrs.morningstar.com/research/431186), which covers, for example, topics such as holding companies and parent/subsidiary relationships, guarantees, recovery, and common adjustments to financial ratios.

The following methodology has also been applied:
-- Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781

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/431153.

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.

DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577