NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the Long-Term Issuer Default Ratings (IDRs) of both Pinnacle West Capital Corp. (PNW) and its vertically integrated electric utility subsidiary, Arizona Public Service Co. (APS) at 'A-'. The Rating Outlook for both PNW and APS is Stable. Additionally, Fitch has affirmed the short-term IDRs of PNW and APS at 'F2'. A full list of rating actions is detailed at the end of this press release. Approximately $4.1 billion of long-term debt is affected by the rating action.
The affirmations reflect solid operating performance at the electric utility, strong credit metrics, an improving service territory economy, and anticipates a balanced outcome in APS's upcoming 2016 General Rate Case (GRC). Fitch expects the Arizona Corporation Commission (ACC) to address rate design issues regarding energy efficiency (EE) and distributed generation (DG) in a credit-supportive manner as rooftop solar continues to expand in Arizona. Fitch expects APS to file its next GRC in June for rates effective mid-2017 and has modeled in a 10% authorized return on equity (ROE) for APS, approximating recent industry averages. The ratings also consider APS and PNW's solid liquidity position, manageable debt maturities, and low leverage. Adverse outcomes in pending rate design and/or future GRC proceedings, signalling deterioration in the current credit-supportive regulatory environment in Arizona, could lead to future negative credit rating actions.
Stable Outlook: The Stable Outlook for APS and PNW reflect the utility's relatively predictable cash flow and a constructive regulatory environment in Arizona. More timely adjudication of GRC proceedings in recent years and the adoption of various rate recovery mechanisms by the ACC has significantly reduced regulatory lag.
KEY RATING DRIVERS
Strong Credit Metrics: Fitch expects APS's credit metrics to remain strong throughout the forecast period and projects EBITDAR coverage of approximately 6x through 2018, on average. Due to high capex EBITDAR, leverage is expected to rise modestly but remain strong at less than 3.5x through the same period.
New 2016 GRC Filing Expected: APS plans to file its next GRC on June 1st for rates effective in mid-2017. This would be APS' first GRC filing in over four years and would include a request to expand APS' partial revenue decoupling mechanism for EE and DG, which, if approved by the ACC, would support APS' credit quality. The filing is also expected to include authorization to defer over $900 million of future costs related to installation of selective catalytic reduction controls at units four and five of the Four Corners coal plant and the natural gas modernization project at the Ocotillo generating plant. The Four Corners and Ocotillo projects are expected to enter commercial operation in 2018 and 2019, respectively. Fitch has modeled a 10% authorized ROE, consistent with APS' current authorized ROE.
AZ Regulatory Compact: GRC orders have been more balanced for APS in the past several years and more timely adjudication of rate filings is a constructive development that has enabled the utility to improve its earned returns. Regulators have adopted several regulatory mechanisms to facilitate cost recovery outside of GRCs. Such cost-recovery mechanisms include the power supply adjustor, renewable energy surcharge, transmission cost adjustor, demand-side management adjustor charge, the environmental improvement surcharge, and the lost fixed-cost recovery (LFCR) mechanism. Fitch believes ACC recognition of an extended post-test-year period for new plant additions and the allowance of a premium rate of return on fair value of rate base is credit supportive. APS' earned ROE for the LTM ended March 31, 2016 was approximately 9.3%, below its authorized ROE of 10%.
Higher Customer Growth: Fitch expects customer growth to average about 1%-2% per year through the forecast period, reflecting improving economic conditions in Arizona, including lower unemployment, rising housing starts and new household formations. APS' year-over-year customer growth was 1.3% in the first quarter of 2016, identical to the 1.3% annual customer growth logged over the four years ended 2015, a marked improvement over the prior three-year period when customer growth averaged 0.6%.
Positive Sales Trend: Fitch expects total weather-normalized retail electricity sales will be about 0.5% on average per year through 2018 as a result of customer growth, net of EE and DG. Retail electricity sales, adjusted to exclude the effects of weather variations, increased 1.3% for the three months ended March 31, 2016, when compared with the prior-year period. This reflects the effects of improving economic conditions and customer growth partially offset by EE, DG, and customer conservation. The delta between customer growth and sales growth has averaged approximately negative 1% over the last four years due to the effects of EE, demand response and DG.
Net Metering Evolving: Net metering (NM) remains a contentious, highly politicized issue in Arizona and is a secular source of concern from a credit perspective. Fitch believes APS' recent announcement to enter into good faith discussions regarding NM-related rate design with the solar leasing industry in Arizona is a modestly constructive development. APS advocates for more balanced rate design in Arizona that addresses the current cost shift between net-metering and non-net metering ratepayers. APS supports a three-part rate design to better reflect fixed costs in rates. Fitch expects APS' 2016 GRC request will include a three-part rate design proposal comprised of a fixed charge, a demand charge and a volumetric component for residential customers. Fitch believes adoption of a more balanced rate design that addresses the current cost shifting issues associated with NM would be positive for APS.
The ACC has opened a generic docket to consider rate design and cost of service hearings on distributed generation and net metering with the findings used to inform prospective GRC filings. Fitch expects the hearings to conclude in June and a decision this summer with the findings to be considered in APS' 2016 GRC. The ACC has also opened a generic docket focused on studying solar DG business models and their effects on corporations and ratepayers, which is currently pending.
Limited DG impact: Currently, the impact of DG is not material to APS creditworthiness given its limited market penetration but could become a concern if growth accelerates materially in the future. DG currently comprises 0.5% or less of the annual negative impact to APS' retail sales growth.
LFCR Mechanism: APS' LFCR mechanism is estimated to offset 30%-40% of revenues lost due to ACC-mandated EE and DG initiatives, subject to an annual year-over-year cap at 1% of revenues. The LFCR is filed by January 15 every year for new rates effective March 1, based on the EE and DG savings from the preceding year. In March the ACC approved APS' 2016 annual LFCR adjustment of $46.4 million for rates effective forthwith.
Large Capex Driving Growth: PNW is targeting rate base growth at APS of 6%-7% through 2018, driven by average annual utility capex of $1.2 billion, levels approximately 25% higher than the preceding three-year period. Capex is focused on generation, distribution and transmission investments and includes emissions control upgrades at APS' coal-fired generating facilities, new transmission capacity, and renewable investments. In Fitch's opinion, credit concern regarding high APS capex is mitigated by a relatively balanced Arizona regulatory compact. On average 70% of capex is recoverable through rate recovery mechanisms and depreciation cash flow, providing relatively timely cost recovery. The extension of bonus depreciation rules late last year is expected to result in approximately $550 million of additional cash flow over the forecast period, reducing anticipated equity needs.
Negative FCF: Due to its large capex program, Fitch expects APS to be moderately free cash flow (FCF) negative through 2018, funding the majority of forecasted capex internally. APS' external capital needs are expected to be funded with a 50/50 mix of debt and equity and Fitch anticipates a modest equity infusion from parent company Pinnacle West Capital Corp. (PNW, IDR:'A-'/Stable Outlook) into APS in 2017 to help maintain the utility's balance capital structure.
Ocotillo Plant Modernization Project: APS plans to increase the capacity of its gas fired Ocotillo power plant to 620MW to help maintain service reliability in the growing Phoenix area. The project is expected to cost $500 million and construction has begun with a projected in-service date during the summer of 2019. This project aligns with APS' strategy of transitioning towards cleaner and more efficient natural gas-fired generation and APS projects this could approximate up to 35% of total generating capacity by 2029, a material increase from 19% in 2015.
APS to Join EIM in October: APS has entered into an agreement with the California Independent System Operator to join their real time energy market, known as the Energy Imbalance Market (EIM), in October. Participation in the EIM will allow APS to access the most efficient generation resources, improve system reliability, and allow for greater integration of renewable generation.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for APS and PNW include:
--A 10% authorized ROE;
--Positive retail sales growth averaging 0.5% per annum;
--Customer growth of 1%-2% per annum;
--Capex averaging $1.2 billion per annum through 2018;
--Anticipated equity infusion from PNW to APS in 2017 to preserve a balanced capital structure.
RATING SENSITIVITIES
Future developments, individually or collectively, that could lead to a positive rating action include:
--Sustained debt-to-EBITDAR leverage metrics under 3.3x;
--Better than expected outcomes in future GRCs and a balanced outcome in pending rate design proceedings to address DG.
Future developments, individually or collectively, that could lead to a negative rating action include:
--Deterioration in the regulatory compact in Arizona;
--An adverse outcome in APS' 2016 GRC;
--Sustained debt-to-EBITDAR leverage metrics over 3.6x;
--A sharp acceleration in competition from DG and/or other emerging technologies.
LIQUIDITY
As of March 31, 2016, PNW had total consolidated liquidity available of $984 million including $14 million of cash and cash equivalents. PNW maintains liquidity through a $200 million unsecured credit facility which matures in May 2021. APS maintains liquidity through two $500 million unsecured credit facilities which mature in May 2021 and September 2020, respectively. Additionally, PNW and APS can upsize their $200 million and $500 million credit facilities to $300 million and $700 million with consent of the lenders. Fitch notes that there were no direct borrowings against these facilities as of March 31, 2016. The credit facilities are subject to a maximum debt-to-capitalization covenant of 65% and as of March 31, 2016 both PNW and APS were in compliance with debt-to-capitalization ratios of 46% and 45%, respectively. PNW's long-term debt maturities are manageable, with $1.1 billion scheduled to mature through 2019 as follows: $358 million in 2016, $125 million in 2017, $82 million in 2018, and $500 million in 2019. Fitch expects PNW to refinance these maturities on a timely basis.
FULL LIST OF RATING ACTIONS
Pinnacle West Capital Corp.:
--Long-term Issuer Default Rating (IDR) affirmed at 'A-' ;
--Senior Unsecured Term Loan assigned a rating of 'A-';
--Short-term IDR affirmed at 'F2';
--Commercial paper affirmed at 'F2'.
Arizona Public Service Co. (APS):
--Long-term IDR affirmed at 'A-' ;
--Senior unsecured affirmed at 'A';
--Short-term IDR affirmed at 'F2';
--Commercial paper affirmed at 'F2'.
Additional information is available on www.fitchratings.com
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1005186
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1005186
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.