Fitch Ratings-New York-September 27: Fitch Rating has downgraded TransAlta Corporation's (TransAlta) IDR to 'BB+' from 'BBB-' and the senior unsecured debt to 'BB+' from 'BBB-.'
The Rating Outlook is revised to Stable from Negative. A key driver for the downgrade is the increased business risk associated with owning a generation fleet with a decreasing level of contracted cash flows coupled with the cancellation of the planned capacity market in Alberta.
Fitch believes TransAlta's cash flow and earnings volatility increases as its contracted cash flows drop to around 50%, down from 80% in 2017, when the hydro and coal power purchase agreements (PPA) in Alberta expire in 2020-2021.
With the United Conservative Party's (UCP) cancellation of a capacity market in Alberta that was to be implemented in 2022, Transalta's generation fleet will be subject to market price and volume volatility.The action also reflects management's strategy to boost shareholder returns through shareholder buybacks and focus on dividends, which, Fitch believes, delays the execution of the company's debt reduction plan.
The change in strategy was facilitated by a $750 million investment from Brookfield Renewable Partners (BRP). BRP's investment comes in the form of convertible debentures and preferred shares, instruments that Fitch considers as a shareholder loan, increasing gross adjusted debt/EBITDA (proportionately consolidating TransAlta Renewables RNW ) to over 4.3x in the near term from Fitch's expectation of 3.0x in 2019.
Key Rating Drivers Long-Term
Merchant Risk Exposure: The primary concern for TransAlta is its exposure to power price volatility for its generation fleet. Fitch estimates that about 50% of EBITDA will come from uncontracted sources as the remaining Alberta coal and hydro PPAs terminate in 2020 and 2021, respectively.
Contracted cash flow was 82% in 2017. With the UCP's cancellation of a capacity market in Alberta that was to be implemented in 2022, Transalta's generation fleet is subject to market price volatility in the Alberta energy-only market. The mothballing of its coal-fired generation assets and an uptick in the oil and gas dominated local economy has contributed to improved market power pricing in 2018-2019, but forward power forecasts point to weakness in 2020-2021 driven by new generation capacity, demonstrating the exposure to increasing amount of cash flow and earnings volatility.
Market Construct in Alberta:
Under the existing energy only construct, Fitch believes TransAlta's earnings profile and business risk faces uncertainty as its exposure to the merchant market grows. While the market is exhibiting a favorable demand-supply dynamic after depressed pricing from 2014-2017, the Alberta market lacks the additional revenue support and forward commitments that capacity markets provide in other markets, such as PJM Interconnection and New England.
Power market pricing fluctuates in response to changes in supply, demand and company strategy and TransAlta's 12-18 month hedging program provides minimal protection against cash flow volatility and commodity price risk. As coal-fired plants are retired by 2030, hastened by the federal tax on carbon coal-fired generation, the expansion of carbon free generation in Alberta could improve TAC's long-term earnings.
Fitch would expect TransAlta's portfolio of renewable capacity, especially the nearly 1 GW of hydro capacity, to be favorably positioned in the dispatch curve.
Parent-Level Deleveraging: Fitch expects TransAlta's gross adjusted debt/EBITDA to increase to over 4.0x in 2019-2020. Fitch partially deconsolidates its 61%-owned subsidiary RNW project-level debt given RNW's separate credit facility and access to the equity market (issued C$150 million in May 2018). While management is committed to a debt reduction program, Fitch believes management has shifted strategy to boost shareholder returns using the proceeds from the BRP loan to fund a C$250 million stock repurchase program and a revised dividend policy, the first change since the dividend reduction in 2016.
BRP's loan comes in the form of convertible debentures and preferred shares, instruments that Fitch considers shareholder loans as a majority stockowner with two Board seats, slowing deleveraging in the near term. Debt reduction of about C$1.6 billion through 2018 was funded from free cash-flow (FCF), coal PPA termination payments, off-coal payment monetization, and proceeds from equity funded drop downs to RNW. With debt reduction of C$600 million through 2020, funded partially from the proceeds of the BRP preferred shares, Fitch expects gross adjusted debt/EBITDA to decline to around 3.6x-3.8x by 2021.
Environmental Regulations Drive Elevated Capital Plans: Federal environmental regulations regarding the carbon tax, closure of all coal-fired plants by 2030 and the extended useful life (by 15 years) for converted coal to gas units appear supportive of TransAlta's capital investment strategy. TransAlta's coal-to-gas conversion for three generation units costing C$100-200 million in 2020-2021, presents modest financial and technological risk. The plants are currently co-firing natural gas from TransAlta's recently completed Tidewater gas pipelines (50% owner), lowering operating costs. It has 393MW of wind projects and a battery project in the U.S. and Canada under construction, costing about 40% of the five year C$2 billion plan, with peak spending in 2019-2020.
In Fitch's opinion, the projects have low financial and construction risk. Conversion of TAC's two coal-fired plants to combined cycle gas fired facilities by 2023-2024, while beyond the current scope of Fitch's rating, has a higher financial and operational risk, operating in a competitive market.
Adequate Financial Flexibility: TransAlta has adequate liquidity, in Fitch's view, to support some volatility in its operating cash flows and meet upcoming debt maturities. TransAlta had access to about C$860 million of liquidity at June 30, 2019, including cash of C$208 million, and is expected to remain FCF positive through 2021. The reduction of parent level debt maturities in 2019-2020 and proceeds from the BRP loan provided some near term flexibility to accelerate TransAlta's capital investment in the clean coal to gas conversion strategy. Funding for development projects at RNW, its growth vehicle, include project level debt and tax equity for projects with long-term corporate PPAs, mitigating the investment requirements at TransAlta.
Derivation Summary
The risk profile of TransAlta is in line with peers The AES Corp (NYSE:AES; BB+/Stable) and Vistra Energy Corp (BB/Positive). TransAlta's asset base is smaller and less diverse in terms of size, scale and geographic and fuel diversity compared to Vistra, the largest independent power producer in the U.S. with approximately 41 GW of generation capacity and AES, which owns and operates 20 GW of generation assets (AES' share) diversified globally.
In comparison, TransAlta has a more concentrated generating fleet, owning 8.3GW of capacity located in Canada, the U.S. and Australia with the majority of cash flow generated in Alberta. Unlike its peers, TransAlta has a dominant position in its primary market. While the level of contracted cash flow is declining in 2021 to 50%, TransAlta's low cost hydro assets are well positioned in the market and provide ancillary services, mitigating market price volatility. The dividend from RNW is generated from long-term contracted asset. Vistra benefits from its ownership of large retail electricity businesses, which are typically countercyclical to wholesale generation given the length and stickiness of customer contracts. Vistra has a dominant position in the mass retail market in Texas, which has generated stable EBITDA over 2012-2018 despite power price volatility.
Favorably, about 25% of TransAlta's generation is from renewable sources, in line with AES at 29% while Vistra doesn't have significant renewable generation.
Fitch expects TransAlta will achieve gross adjusted debt/EBITDA of less than 4.0x by 2021, above Vistra's gross debt/EBITDA projected at 2.7x by 2021, and lower than AES's recourse debt/APOCF (adjusted parent-only cash flow) projected at 4x by 2019.
Key Assumptions
Fitch's Key Assumptions Within Our Rating Case for the Issuer
- Operate under Alberta PPAs for coal and hydro expiring in 2020 and 2021 under current market conditions;- Power prices in Alberta of approximately C$55 /MWh in 2019 and escalating thereafter (Fitch uses Wood Mackenzie as its third-party consultant);
- Capital spending ranging from C$75 -- 250 million from 2019-2022 for gas conversion projects and C$275 -- 375 million from 2019-2020 for the RNW projects;
- Stable ownership level (61%) of RNW;
- RNW project-level debt for construction funding of U.S. wind projects, either through project debt or tax equity;- Debt issuance limited to refinancing, no equity issuance over the rating horizon with the exception of DRIP at RNW in 2019.
RATING SENSITIVITIES
Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Although not expected over the rating horizon, ratings could be upgraded if gross adjusted debt/EBITDA declined to 3.0x or less, on a sustainable basis.
--Another factor potentially leading to a positive rating action is that Fitch believes that cash flow stability materially increases for a sustained period, either through changes in the market construct or other market factors stemming from TransAlta's market position.Developments That May, Individually or Collectively, Lead to Negative Rating Action
--The ratings could be lowered if Fitch believes that gross adjusted debt/EBITDA will remain materially above 4.3x for a sustained period.
--Other factors potentially leading to a negative rating action include less than 30% of EBITDA comes from long-term contracted assets beyond 2020; and/or cash flow volatility increases due to wholesale electricity price volatility.
Liquidity and Debt Structure Adequate Liquidity: TransAlta has adequate liquidity, in Fitch's opinion, with modestly positive FCF generation over the rating horizon, supplementing significant availability under committed credit facilities. As of June 30, 2019, TransAlta had a $1.25 billion credit facility, of which C$654 million was available, and C$208 million of cash. TransAlta's credit facilities were recently amended and renewed until 2023. TransAlta and RNW have independent financing facilities but TransAlta provides financial support to RNW through currency hedges and PPAs with RNW's wind facilities in Alberta. TransAlta's next significant maturity is C$400 million due in 2020. TAC is in compliance with the terms of the credit facilities. Additionally, RNW has C$966 million project level debt with limitations on distributions to TAC based on project specific coverage tests.
All of RNW's project have met their tests and will not limit distributions. Summary of Financial Adjustments Under Fitch's rating methodology for hybrid instruments, TransAlta's C$942 million preferred shares are given 50% equity credit. Under Fitch's corporate criteria, Fitch does not accord any equity credit to the $350 exchangeable debentures and views the instrument as a shareholder loan because Brookfield is a major shareholder with Board representation. RNW is proportionately consolidated (based on TransAlta's ownership share) into TransAlta. ESG Considerations Unless otherwise disclosed in this section, the highest level of Environmental, Social and Governance (ESG) credit relevance is a score of 3. ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity.
For more information on our ESG Relevance Scores, visit www.fitchratings.com/esg. TransAlta Corporation; Long Term Issuer Default Rating; Downgrade; BB+; RO:Sta ----senior unsecured; Long Term Rating; Downgrade; BB+ Contacts: Primary Rating Analyst Jodi Hecht, Director +1 646 582 4969 Fitch Ratings, Inc. 33 Whitehall Street New York 10004 Secondary Rating Analyst Michael Ruggirello, CFA Associate Director +1 416 644 6586 Committee Chairperson Philip Smyth, CFA Senior Director +1 212 908 0531
Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com. Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria (pub. 09 Nov 2018)
https://www.fitchratings.com/site/re/10051058 Corporate Rating Criteria (pub. 19 Feb 2019) https://www.fitchratings.com/site/re/10062582 Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10024585
Parent and Subsidiary Rating Linkage - Effective from 16 July 2018 to 27 September 2019 (pub. 16 Jul 2018) https://www.fitchratings.com/site/re/10036366 Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/site/dodd-frank-disclosure/10091160 Solicitation Status https://www.fitchratings.com/site/pr/10091160#solicitation Endorsement Policy https://www.fitchratings.com/regulatory
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