Ontario Power Generation Inc. is the entity that raises debt on behalf of the regulated operations and whose debt is rated. In 2006, the regulated operations of OPG accounted for approximately 60% of the company’s total revenues and total generation. Thus, the views of the debt rating agencies with respect to OPG may provide some useful information regarding an appropriate stand-alone capital structure for the regulated operations.
D.1. DBRS
DBRS, which rates OPG’s unsecured debt as A(low)88, considers the key strengths of OPG as they relate to regulated operations to be:
a) Shareholder support; b) Dominant market position;
c) More favourable interim regulatory framework relative to previous framework; d) Nuclear waste management liabilities limited due to agreement with the Province.
The challenges related to regulated operations, in DBRS’ view include:
a) Interim regulatory framework less favourable than in other North American jurisdictions; b) Higher operating and financial risks associated with nuclear generation equipment; c) Political intervention;
d) Significant capital program anticipated.
The sole challenge listed by DBRS that is unique to the unregulated operations is fuel cost risk associated with coal generation. Thus, it would be reasonable to conclude that DBRS views the
regulated operations as facing no less business risk than the unregulated operations. As such, DBRS’ evaluation of the consolidated financial metrics and its resulting debt rating decision can be viewed as applicable to the regulated operations on a stand-alone basis.
DBRS notes that while OPG’s cash flow-to-debt and interest coverage ratios have improved significantly and are strong relative to peers’ (cash flow-to-debt ratio of 21.1% and fixed charge coverage of 4.55X in 2005, compared to 7.7% and 0.7X in 2004), the debt rating is limited by uncertainties with respect to closure of coal generation facilities, nuclear refurbishment, new nuclear build and the direction of regulation beyond 2008. The rating agency also referred to the fact that “OPG’s regulated rates are based on an ROE of 5%, which is low in comparison to what the majority of other regulated generation companies receive in other jurisdictions in North America”, and is lower than the ROEs of regulated transmission and distribution in Ontario, both of which have a lower business risk profile than generation. DBRS commented that regulated vertically integrated utilities in the U.S. have deemed capital structures ranging from 35% common equity to 55% common equity and have an approved ROE ranging from 9.75% to 13.5%. According to DBRS, a comparable entity to OPG (that is, one without stable transmission and distribution operations), according to DBRS, would be near the top of both ranges. DBRS concluded that if long-term certainty develops with respect to uncertainties related to local plant closures, nuclear refurbishment and new build, regulation beyond 2008, the level of allowed returns, and if financial ratios remain strong, it may consider a positive rating action.
The A(low) rating currently accorded OPG’s consolidated operations, and which, as noted in IV.A.1, as of August 2006, was more “reflective of OPG’s improved financial profile on a stand- alone basis” reflects a 2005 common equity ratio of close to 60%, a return on equity of 11.7% and the coverage ratios cited above.
D.2. Standard & Poor’s
As noted above, Standard & Poor’s rating for OPG of BBB+ reflects a two notch enhancement due to its relationship with its shareholder, the Province of Ontario. S&P views OPG’s principal credit strengths as: 89
a. Government ownership and implied financial support;
b. Fixed price for output from baseload nuclear and hydroelectric assets; c. Diversified portfolio of generating assets; and
d. Strong cost-competitive position in its primary market.
Partially offsetting the credit strengths are:
a. Operational and technology risk associated with nuclear assets;
b. Non-regulated cash flow constraints related to unregulated operations due to a government-imposed revenue cap;
c. Volume risks on unregulated assets; and d. An intermediate financial profile.
S&P’s assessment of OPG’s credit strengths and weaknesses suggests that it views the regulated operations as facing no less business risk than the unregulated operations, given its focus on the operational and technology risk of the nuclear facilities. Consequently, the recent consolidated financial parameters should be viewed as reflective of the level consistent with a stand-alone rating for the regulated operations in the BBB category.
S&P reported a 2006 debt/capital ratio of 55.6% versus 63.9% in 200590, reflecting its 2006 adoption in Canada of a measurement methodology that makes analytical adjustments to amounts reported in companies’ financial statements and treats items such as unfunded OPEBs, pension fund deficits and operating leases as debt for purposes of calculating capital structure ratios.91 The 2006 and 2005 Adjusted Funds from Operations Interest Coverage ratios were 3.7X and 4.9X respectively; the corresponding Adjusted Funds from Operations to Total Debt ratios were 10.6% and 14%.92 S&P’s expectation is that the financial profile will remain relatively stable in 2007 absent any material changes to financial policies or capital structure. S&P maintains a positive outlook on the rating, indicating that it:
reflects an improved pricing framework and regulatory environment. The rating will likely move a notch higher if OPG can manage its expenses and operational performance within the bounds of its current license agreement and maintain its satisfactory financial profile in 2007 with a similar outlook for 2008 and beyond. For the rating to move a notch higher, there will also have to be an expectation of continued relative stability in both Ontario's electricity policy and regulatory framework and a clear financial policy for the company. The outlook could be revised to stable or negative as a result of a sustained period of significantly lower-than-expected electricity production due to operational or technological challenges at the company's nuclear facilities, or higher operating expense due to poor hydrology and higher prices for coal, with no related increase to the revenue cap. As the shareholder relationship evolves in the long term, there could be a change to the degree of support factored into the rating.
Based on both debt rating agency reports, the current debt ratings for the consolidated operations of OPG are based on common equity ratios, as measured by external debt and equity, in the range of 55-60%. To achieve and maintain similar stand-alone investment grade debt ratings, the deemed common equity ratio for the regulated operations would need to be in a similar range.
90 Standard & Poor’s, CreditStats: Electric Utilities – Canada, September 10, 2007. Based on the methodology used by S&P prior to adopting analytic adjustments for these items, the 2005 debt ratio, based solely on debt and equity, would have been reported by S&P as 44%.
91 In its December 2005 report for OPG, S&P reported the 2004 debt/capital ratio at 42.7% based on reported amounts of debt and equity; in the September 2006 and 2007 CreditStats, with S&P’s analytic adjustments, it was reported to be 56.5%.