Morningstar DBRS Confirms Credit 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).

KEY CREDIT RATING CONSIDERATIONS
The credit ratings confirmation stems from the Company's expectation that its operations will return to its historical performance starting in April 2025 after experiencing major unplanned outages to the Unit 1 Generator (Unit 1) in 2023 as a result of the failed piston head studs (subsequently returned to service in March 2024) and a larger-than-expected repair scope to the Unit 2 Generator (Unit 2) in 2024-25 (after the discovery of the unexpected damage to the Unit 2 runner hub) that extended the planned outage to April 2025 from July 2024.

Despite the significant operational challenges that the Company experienced in 2023-24, the Unit 1 repair cost and the loss of revenue were largely covered by the insurance proceeds. As a result, the Company was still able to generate a debt service coverage ratio (DSCR) of about 1.70 times (x) (after including the liquidated damages of about $13 million) in F2024 (fiscal-year ends in March). Although DSCR is projected to decline to 1.65x in F2025 (insurance proceeds for Unit 2 did not fully offset the additional loss of revenue and the additional repair cost), Unit 2 is expected to fully resume operations in April 2025. Hence, the Company expects financial performance in F2026 will return to its historical level at above 2.00x.

CREDIT RATING DRIVERS
A positive credit rating action is unlikely because the current credit 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 on a sustained basis because of persistent operational challenges (including a material increase in the operating and/or capital cost projections).

FINANCIAL OUTLOOK
According to the Company's F2026 budget, DSCR is expected to increase to 2.32x from a projected DSCR of 1.65x in F2025 after the recommencement of operations on the Unit 2 in April 2025. Nevertheless, under Morningstar DBRS' base-case scenario, the Company's minimum DSCR is projected to be around 1.84x.

CREDIT RATING RATIONALE
Originally, the Company planned to shut down Unit 2 in February 2024-July 2024 to repair the piston head studs (to mitigate any potential future unplanned outages related to the Unit 1 outage). However, during the disassembly of Unit 2, an internal inspection performed by the Company discovered damage to the runner hub and cone fasteners. This internal inspection is part of the planned maintenance program, and it is completed every four years. During the most recent inspection in April 2023, there were no signs of any damage. As a result of the unexpected damage, the Company had to perform additional repairs to Unit 2 (incur an additional repair cost of about $5.7 million) and extend the planned outage period to April 2025.

As a result, the Company expects the DSCR will decline to 1.65x in F2025. This is considerably lower than last year's budget of 1.98x. The lower-than-expected DSCR in F2025 was primarily because the insurance proceeds were insufficient to fully offset the additional loss of revenue and the additional repair cost of Unit 2. The Company confirmed that the Unit 2 repair scope included the redesign of the runner hub linkages, and the Company's insurance coverage does not include betterments or redesign. Therefore, the costs and associated time for the redesign engineering and manufacturing were not covered. Following the completion of the Unit 2 repair in April 2025, the Company is projecting DSCR to return to its historical level at above 2.0x in F2026.

Morningstar DBRS notes that the owners have been supportive despite major operational challenges experienced by the Company in 2023-24. The owners provided equity support to mitigate any liquidity shortfall throughout the Unit 1 outage period in 2023, and they also chose not to receive any dividends in 2023-24.

Based on the Company's forecast, capital expenditure (capex) in F2025 is projected to be about $4.6 million, which is about 28% higher than budgeted last year. The higher-than-expected spending is due to the advancement of the digital governor excitation controls upgrade (which was delayed in 2023-24 due to the reallocation of resources to the Unit 1 and Unit 2 repair works) with materials arriving in F2025. In addition, the scope of the intake gate refurbishment project has increased because there is more wear than originally anticipated when the capital budget was produced last year. Lastly, the Company had to replace several transmission line poles, which were not included in last year's capital budget.

Capex in F2026 is budgeted to decrease to $4.2 million, which includes multiyear projects, such as the digital governor excitation controls upgrade and intake gate 1 and 6 refurbishments that are projected to account for approximately 50% of the total capital budget. Capex is forecast to decline to about $1 million annually in F2027-F2030 after the completion of the intake gates refurbishment and the digital governor excitation controls upgrade project.

Morningstar DBRS understands the Government of Canada (Canada) and the United States (U.S.) reached an agreement-in-principle (AIP) to modernize the Columbia River Treaty (the Treaty) in July 2024. The AIP is not legally binding, and the current or existing terms of the Treaty is in place until both countries reach a final agreement. The Treaty is a transboundary water-management agreement between Canada and the United States (ratified in 1964) that optimizes flood-risk management and power generation in both countries. Under the AIP, the countries have agreed to incorporate new provisions not considered in the current Treaty, including those for increased unilateral flexibility for how the Province of British Columbia (Province) operates its treaty dams for domestic priorities such as for ecosystem improvements, and supporting Indigenous cultural values and community interests. However, as a result of a change in the U.S. administration in January 2025, the discussions between Canada and the U.S. in amending the Treaty are currently paused.

The Company confirmed that the AIP isn't expected to materially change the operating regime of the dam, and hence, the fixed annual energy entitlement at 767 gigawatt hours (GWh) is expected to remain unchanged. At this time, the current Treaty continues to be in place, and it can only be terminated with 10 years of advance notice.

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
There were no Environmental, Social, or 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) https://dbrs.morningstar.com/research/437781.

RATING DRIVERS AND FINANCIAL RISK ASSESSMENT (FRA)

(A) Weighting of BRA Factors
In the analysis of ALPC, the Rating Driver factors listed in the methodology are considered in the order of importance.

(B) Weighting of FRA Factors
In the analysis of ALPC, the following FRA factor listed in the methodology was considered more important.
-- DSCR (the only applicable FRA)

(C) Weighting of the BRA and the FRA
In the analysis of ALPC, 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:

Global Methodology for Rating Project Finance (December 10, 2024)
https://dbrs.morningstar.com/research/444393

Morningstar DBRS credit ratings may use one or more sections of the Morningstar DBRS Global Corporate Criteria (February 3, 2025) https://dbrs.morningstar.com/research/447186/morningstar-dbrs-global-corporate-criteria, 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 ESG 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 https://dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

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