CHICAGO--(BUSINESS WIRE)--Fitch Ratings has upgraded the Issuer Default Rating (IDR) of Appalachian Power Company (APCO) to 'BBB' from 'BBB-'. Fitch has also affirmed the IDRs of American Electric Power Company Co (AEP) and its other operating regulated utilities as follows: Ohio Power Co.(OPCO), AEP Texas Central Company (TCC) and AEP Texas North Company (TNC) at 'BBB+'; Public Service Company of Oklahoma (PSO) at 'BBB'; and Indiana Michigan Power Company (IMPCO), and Kentucky Power Company (KPCO) at 'BBB-'. All Rating Outlooks remain Stable. A full list of the ratings follows at the end of this release.
Rating Upgrade for Appalachian Power Co
The upgrade of APCO's IDR to 'BBB' from 'BBB-' reflects an above-expectation decline in financial leverage driven by strong operating performance and a lull in capex. Fitch expects adjusted debt/EBITDAR to remain below 3.5x during the rating horizon, which is commensurate with a 'BBB' IDR for an integrated utility company.
KEY RATING DRIVERS
Key Rating Drivers for American Electric Power Co
Balanced Regulatory Construct: Fitch views the state regulatory constructs as balanced within AEP's service territories. Authorized returns on equity (ROEs) are close to the industry average in most jurisdictions and include provisions to mitigate commodity and environmental regulation risks. Recent favorable outcomes to general rate cases (GRCs) and incremental rider mechanisms resulted in a 60bps improvement in consolidated earned ROE in 2015 to 9.6% compared to the prior year. Fitch expects the earned ROEs to continue to modestly edge higher over 2016 - 2018.
Evolving Merchant Fleet: Low electricity demand and a weak pricing environment will persist over the forecast period, in Fitch's opinion, depressing margins in the merchant business (close to 10% of consolidated EBITDA). Fitch views AEP's endeavours to reduce exposure to the volatile merchant environment via negotiation of a long-term PPA in Ohio and potential divestment of the remaining non-contracted generation assets positive to its credit profile.
Fitch believes that the support of the Public Utilities Commission of Ohio (PUCO) staff significantly improves the prospects for approval of the joint stipulation in Ohio for an eight-year PPA. Nonetheless, the stipulation has been challenged by a number of parties and PUCO approval is not assured. The PUCO may adopt the stipulation as proposed, adopt the stipulation with modification or reject the proposed stipulation. In any event, the likelihood is high that the PUCO order will be challenged in courts and could likely draw a review of the affiliate PPA standards by the Federal Regulatory Energy Commission.
Large Capex Spending: Fitch's model includes management's forecasted capex spending of about $5 billion annually in 2016 - 2018, almost exclusively geared to growing the regulated rate base. About $7.3 billion of capex spending through 2018 targets Federal Energy Regulatory Commission (FERC)-regulated transmission assets, which earn attractive and contemporaneous returns on investment. The extension of bonus depreciation reduces the strain of the elevated capex plan on AEP's credit metrics.
Strong FFO Based Credit Metrics: AEP's FFO based leverage and coverage metrics are strong for the current ratings at 3.5x and 4.6x, respectively, at year-end 2015. Fitch expects these metrics to sustain at these levels over the forecast period of 2016 - 2018. Adjusted debt/EBITDAR is consistent with the current ratings, but Fitch expects it to weaken to roughly 4.0x over the rating horizon due to the elevated capex plan and regulatory lag.
Diversified Business Profile: AEP's ownership of nine regulated electric utilities operating in 11 states and its growing investments in FERC-regulated transmission projects provide regulatory, geographic and cash flow diversity. Fitch forecasts almost 90% of AEP's consolidated EBITDA will come from regulated businesses over the rating horizon.
Rating Linkages: The regulated subsidiaries have operational, financial and functional ties to AEP resulting in a moderate level of ratings linkage. The treasury function is centrally managed and all regulated subsidiaries depend on AEP for short-term liquidity and participate in AEP's money pool. The money pool allows the utilities to manage working capital needs and provides short-term financing. Legal ties are weak as the parent does not guarantee the debt obligations of its regulated subsidiaries. Each of the subsidiaries also has limitations on capital structure emanating from covenants in the bank credit agreement (debt to total capitalization that does not exceed 67.5%) and from regulatory requirements to maintain a specific equity ratio. There are no cross default provisions amongst AEP and its subsidiaries.
Due to these linkages, Fitch typically limits the notching difference between AEP and its subsidiaries to one-to-two notches. Furthermore, Fitch typically restricts the notching difference between subsidiaries participating in a money pool to one rating category. Regulated subsidiaries are rated lower and/or higher than AEP reflecting the strength of their respective balance sheet, the quality of their service area and the constructiveness of their regulatory environment.
Key Rating Drivers for Appalachian Power Co
Improved Credit Metrics: Satisfactory outcome to general rate cases in West Virginia, effective rate adjustment mechanisms in Virginia and cost-reduction programs have led to an increase in the earned ROE by ~200bps to 9.4% in 2015, compared with 2014. Fitch expects earned ROE to further improve in 2016 driven by the full year effect of the 2015 GRC. The improved financial performance, combined with a lull in capex, results in declining financial leverage. Fitch considers APCO's credit metrics, including adjusted debt/EBITDAR remaining around 3.5x through 2018, to be commensurate with a 'BBB' rating.
Challenging Regulatory Environment: Fitch considers the regulatory environment in West Virginia to be somewhat restrictive. However, the approval in May 2015 of a base rate increase of $99 million based on a 9.75% ROE was in line with Fitch's expectations. The regulatory environment in Virginia is generally more constructive, with various riders mostly offsetting the freezing of base retail rates until 2020. Fitch expects the outcome of the pending general rate case in Tennessee to only have a marginal impact on APCO's credit profile, given the small size of the rate base.
Clean Power Plan: APCO is gradually transitioning its coal-dominant generation fleet, about 61% of capacity at year-end 2015, toward gas-fuelled plants with renewable generation being added to the mix starting in 2016. Environmental riders in both jurisdictions and below average retail electricity rates provide APCO some flexibility to recover potentially higher expenditures to meet environmental regulation while maintaining an attractive ROE.
Key Rating Drivers for Indiana Michigan Power Co
Resilient Credit Metrics: A $1.5 billion capex plan for 2016 -2018 will stress credit protection measures, in Fitch's opinion, but the extension of the bonus depreciation should alleviate most of the pressure. The capex plan includes approximately $640 million for the life extension of the Cook nuclear plant. About 65% of Cook-related expenditures are attributable to Indiana and recoverable near contemporaneously through a rider mechanism. Fitch forecasts IMPCO's credit metrics to weaken modestly through 2018 compared with a relatively strong year-end 2015, with adjusted debt/EBITDAR hovering around 4.0x - 4.25x in 2016 - 2018.
Supportive Regulation: IMPCO's ratings reflect favourable regulatory constructs in Indiana and Michigan that provide recovery riders for environmental upgrades, fuel costs, energy-efficiency programs and other costs. The nuclear power plant life extension project has been preapproved by Michigan regulators but will require a general rate case filing to recover the investment, introducing some regulatory lag.
Key Rating Drivers for Kentucky Power Co
Regulatory Activity: The regulatory environment in Kentucky is relatively constructive, in Fitch's opinion. The $45 million settlement to KPCO's GRC approved in June 2015 was in line with Fitch's expectations. The rate increase is mostly related to the Mitchell power plant acquisition and recovery of the unamortized costs of the Big Sandy coal plant retired in May 2015. The settlement included incremental riders for environmental surcharges, fuel cost adjustments and various other items. Fitch expects earned ROE to return closer to the industry average in 2016 - 2018, supported by the rate case decision and the cost-saving program.
Rebound in Credit Metrics: KPCO's weak credit metrics in 2015 were primarily driven by the disallowance of $54 million in fuel cost fees related to the Mitchell power plant; therefore, Fitch expects significant improvement in 2016. Fitch forecasts adjusted debt/EBITDAR to return closer to 4.0x through to 2018, which is consistent with Fitch's guideline ratios for utilities rated 'BBB-'.
High Proportion of Coal in the Fuel Mix: KPCO's 100% coal mix, about 75% after a planned plant conversion in 2016, leaves the utility exposed to potentially higher environmental expenditures. While KPCO has an environmental clause allowing for recovery of mandated expenditures, retail electricity rates would rise, reducing flexibility for KPCO to earn an attractive ROE and potentially inviting political scrutiny.
Key Rating Drivers for Public Service Co. of Oklahoma
Rate Case Settlements: The Oklahoma Corporation Commission (OCC) adopted in April 2015 a revenue-neutral settlement to PSO's GRC filing. Concurrently, the OCC approved a rider to implement automated metering infrastructure (AMI). While the adjudication was slightly below our expectations, Fitch believes that the regulatory environment in Oklahoma remains supportive. In July 2015, PSO filed a GRC seeking a $172 million rate increase, mainly for environmental compliance costs, with a decision expected during second-quarter 2016. Fitch base case scenario assumes approval of a rate base increase of about $75 million.
Pressure on Credit Metrics: PSO's capex program is higher than average in 2015 - 2016 due to the replacement of aging power plants, environmental upgrades and installation of AMI, and will pressure the company's credit metrics over the rating horizon. Fitch anticipates adjusted debt/EBITDAR to peak in 2016, followed by deleveraging closer to 4.1x by 2018.
Favorable Operating Environment: The ratings reflect PSO's relatively predictable earnings and cash flows, very competitive retail rates, management's conservative strategy focused on integrated utility operations in Oklahoma, a constructive regulatory environment and a generation fleet generally compliant with environmental regulations.
Key Rating Drivers for Southwestern Electric Power Co
Improving Credit Protection Measures: Fitch expects adjusted debt/EBITDAR to improve below 4.0x by 2018, compared with 4.2x at year-end 2015, as the implementation of approved rate increases should partly offset the elevated capex program.
Rising Environmental Compliance Costs: Approximately 55% of SWEPCO's generation capacity is coal- and lignite-fired, leaving the utility exposed to potentially higher environmental expenditures. While SWEPCO has an environmental clause allowing for recovery of mandated expenditures in Louisiana, Arkansas and Texas, regulations require it to file general rate case applications to cover these costs, creating a recovery lag for the investment. Furthermore, the retail electricity rates would rise, reducing flexibility for SWEPCO to earn an attractive ROE and potentially inviting political scrutiny.
Regulatory and Cash Flow Diversity: The three utility jurisdictions -- Arkansas, Louisiana and Texas -- provide SWEPCO with geographic and regulatory diversity. A balanced regulatory environment, which includes fuel cost adjustment clauses and cost riders to recover environmental regulation-related expenses, is a key driver of SWEPCO's credit profile.
Key Rating Drivers for Ohio Power Co
Constructive Regulatory Settlement: The electricity security plan (ESP) is supportive of OPCO's credit profile. The main provisions of the ESP include approval of DIR for investments in distribution infrastructure and a deferred asset recovery rider through 2018. The ESP establishes a 10.2% ROE and a debt/capital ratio of 52.5% for OPCO's capital structure.
Strong Credit Metrics: OPCO plans $1.4 billion of capex through 2018, supporting a 6% compound annualized rate base growth. Supportive regulatory construct will minimize the impact of the capex plan on the balance sheet and Fitch expects OPCO's adjusted debt/EBITDAR ratio to remain around 3.25x through 2018, which is strong for the current ratings.
PPA with AEP Generation: Fitch does not expect the proposed PPA with AEP Generation Resources Inc. to have a material impact on OPCO's credit profile, as OPCO's ESP provides for the pass through of its cost of power to serve standard-service-offer customers. Full revenue decoupling provides additional earnings stability. Nonetheless, the highly controversial nature of the stipulation casts regulatory ambiguity creating, in Fitch's view, some downside risk to OPCO's allowed ROE and/or ability to earn its allowed ROE.
Key Rating Drivers for AEP Texas Central Co and AEP Texas North Co
Pressured Credit Metrics: Fitch expects TCC's and TNC's adjusted debt / EBITDAR to be pressured, at 4.2x - 4.6x over the rating horizon, reflecting continued investment in the rate base with a regulatory lag. However, Fitch expects FFO-adjusted leverage to remain commensurate with the current ratings at 4.1x - 4.4x by 2018. The ratings affirmation reflects TTC and TNC financial flexibility in their funding strategy and access to a well-capitalized parent, which could provide upside to the credit metrics going-forward.
Low-Risk Business Profile: TCC and TNC own and operate regulated electricity distribution and transmission networks under a cost of service-based regulatory framework in Texas. Neither company has any exposure to commodity prices. Fitch considers operational and geographical ties between TCC and TNC as fundamental factors in aligning the IDRs of both companies. TCC has larger operations than TNC and its credit profile supports TNC's credit profile and the IDR. TNC's partial interest in a power plant co-owned with an affiliate is leased to a non-affiliated company through 2027.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for AEP and its subsidiaries include:
--Annual volumetric increase in sales at operating companies between 0.5% - 1% over next three years;
--For the concluded regulatory activities, Fitch's financial model includes implementation of GRC settled during 2015 in Virginia, Oklahoma, West Virginia and Kentucky;
--For pending GRC applications, Fitch assumptions include a $75 million rate increase in Oklahoma and a $5 million rate increase in Tennessee;
--Management's publically available forecasts for capex, dividends, and equity issuance;
--Fitch used independent consultant's projections for power prices and actual capacity prices in PJM to forecast EBITDA for AEP's competitive generation business;
--Interest rate assumption for AEP and its subsidiaries at 5%; and
--Fitch's base case assumptions do not include the approval of the Ohio joint stipulation and/ or the divestiture of the remaining merchant fleet.
RATING SENSITIVITIES
Rating Sensitivities for American Electric Power Co
Positive Rating Action: Future developments that may, individually or collectively, lead to a positive rating action include:
--Upward migration in ratings of its regulated subsidiaries;
--Adjusted debt / EBITDAR below 3.75x on a sustainable basis; and
--Significant reduction in the exposure to competitive energy markets such as implementation of the PPA in Ohio and divestiture of the remaining merchant generation assets.
Negative Rating Action: Ratings could be downgraded if management were to pursue a more aggressive growth or financial strategy such that adjusted debt/EBITDAR and FFO-adjusted leverage ratios exceed 4.0x and 5.5x, respectively, on a sustainable basis.
Rating Sensitivities for Appalachian Power Co
Positive Rating Action: Positive rating actions may be considered if adjusted debt/EBITDAR improves to below 3.25x on a sustained basis.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Stringent new environmental rules leading to elevated capex;
--Adverse changes to the regulatory framework; and
--Adjusted debt/EBITDAR exceeding 3.75x on a sustained basis.
Rating Sensitivities for Indiana Michigan Power Co
Positive Rating Action: An upgrade of IMPCO is considered unlikely over the next 12 - 18 months, given the expected impact of the large capex program on the credit metrics over the next three years. However, positive rating actions may be considered if adjusted debt/EBITDAR is maintained below 3.75x on a sustained basis.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Stringent new environmental rules leading to elevated capex;
--Adverse changes to the regulatory framework; and
--Adjusted debt/EBITDAR exceeding 4.4x on a sustained basis.
Rating Sensitivities for Kentucky Power Co
Positive Rating Action: An upgrade of KPCO is considered unlikely over the next 12 - 18 months, given the credit metrics and high concentration of coal in the fuel mix. However, positive rating actions may be considered if adjusted debt/ EBITDAR improves below 3.75x on a sustained basis.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Stringent new environmental rules leading to elevated capex;
--Adverse changes to the regulatory framework; and
--Adjusted debt/EBITDAR exceeding 4.4x on a sustained basis.
Rating Sensitivities for Public Service Co. of Oklahoma
Positive Rating Action: Positive rating actions may be considered if constructive regulatory rulings, cost saving initiatives, or other actions result in adjusted debt to EBITDAR falling below 3.5x on a sustained basis.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Stringent new environmental rules leading to elevated capex;
--Adverse changes to the regulatory framework; and
--Adjusted FFO leverage rising above 5.5x on a sustained basis.
Rating Sensitivities for Southwestern Electric Power Co
Positive Rating Action: Positive rating actions may be considered if constructive regulatory rulings, cost saving initiatives, or other actions result in adjusted debt to EBITDAR falling below 3.75x on a sustained basis.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Stringent new environmental rules leading to elevated capex;
--Adverse changes to the regulatory framework; and
--FFO-adjusted leverage rising above 6.0x on a sustained basis.
Rating Sensitivities for Ohio Power Co
Positive Rating Action: Positive rating action is not likely at this time as OPCO's ratings are constrained by its participation in a money pool with regulated affiliates that are rated two-notches lower.
Negative Rating Action: Future developments that may, individually or collectively, lead to a negative rating action include:
--Adjusted debt/EBITDAR and FFO-adjusted leverage ratios rising higher than 3.75x and 5.0x, respectively, on a sustained basis; and
--Significant adverse changes to the regulatory framework, including transfer of material exposure to wholesale power prices under a PPA agreement.
Rating Sensitivities for AEP Texas Central Co. and AEP Texas North Co.
Positive Rating Action: An upgrade of TCC and TNC is unlikely over the next 12 - 18 months given the expected downward pressure by the capex plans on the credit metrics in 2016 - 2018. However, positive rating action could be implemented if TCC and TNC implement a financing and dividend strategy that keeps adjusted debt / EBITDAR below 3.5x.
Negative Rating Action: A negative rating action would be triggered if financing for the planned capex, or adverse regulatory outcome, result in FFO-adjusted leverage exceeding 5.0x for a sustained period.
LIQUIDITY
AEP had approximately $3.5 billion of total liquidity available at the end of 2015, including $3.3 billion available under two equal revolving credit facilities maturing in June 2017 and July 2018. The credit facilities also serve as a backstop for AEP's commercial paper program and letters of credit. Subsidiaries' excess cash balances and short-term borrowing needs are centralized into two money pools, segregating regulated and nonregulated activities. Operating subsidiaries rely on AEP for their cash and treasury management, but access the capital markets independently for their long-term borrowings needs. Utility money pool borrowings and long-term financing may be limited by regulatory orders for individual subsidiaries.
AEP and its subsidiaries regularly access the debt markets to fund capex and refinance maturing obligations. The debt maturities over the 2016-2018 rating horizon are manageable, and Fitch expects them to be refinanced at competitive rates.
AEP must maintain a ratio of debt to total capitalization that does not exceed 67.5%, per the covenants to its credit agreement. AEP stood comfortably within this guideline at 50.2% at the end 2015.
FULL LIST OF RATING ACTIONS
Fitch upgrades the following ratings:
Appalachian Power Co
--Long-term IDR to 'BBB' from 'BBB-';
--Senior unsecured debt and Pollution Control Revenue Bonds (PCRBs) to 'BBB+' from 'BBB'.
The Rating Outlook is Stable.
Fitch affirms then withdraws the following ratings:
AEP Texas Central Co
--Short-term-term IDR at 'F2'.
AEP Texas North Co
--Short-term-term IDR at 'F2'.
Ohio Power Co
--Short-term-term IDR and commercial paper at 'F2'.
Public Service Co of Oklahoma
--Short-term-term IDR at 'F2'.
Fitch affirms the following ratings:
American Electric Power Co
--Long-term IDR at 'BBB';
--Senior unsecured debt at 'BBB+';
--Short-term IDR and commercial paper at 'F2'.
Indiana Michigan Power Co
--Long-term IDR at 'BBB-';
--Senior unsecured debt and PCRBs at 'BBB'.
Kentucky Power Co
--Long-term IDR at 'BBB-';
--Senior unsecured debt at 'BBB'.
Public Service Co of Oklahoma Co
--Long-term IDR at 'BBB';
--Senior unsecured debt at 'BBB+'.
Southwestern Electric Power Co
--Long-term IDR at 'BBB-';
--Senior unsecured debt at 'BBB'.
Ohio Power Co
--Long-term IDR at 'BBB+';
--Senior unsecured debt and PCRBs at 'A-'.
AEP Texas Central Co
--Long-term IDR at 'BBB+';
--Senior unsecured debt and PCRBs at 'A-'.
AEP Texas North Co
--Long-term IDR at 'BBB+';
--Senior unsecured debt at 'A-'.
The Rating Outlook is Stable.
Date of Relevant Rating Committee: 17 March, 2016.
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
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