arizona power authority · 6/27/2017 · and demand risk borne by apa relative to the former...

U.S. PUBLIC FINANCE

CREDIT OPINION27 June 2017

Update

Contacts

Thomas Brigandi 212-553-2985Associate [email protected]

Kurt Krummenacker 212-553-7207Senior Vice President/[email protected]

Dan Aschenbach 212-553-0880Senior Vice [email protected]

A.J. Sabatelle 212-553-4136Associate [email protected]

Arizona Power AuthorityUpdate - Moody's upgrades Arizona Power Authority'sRevenue Bonds to Aa1 from Aa2; outlook stable

Summary Rating RationaleMoody's Investors Service has upgraded the Arizona Power Authority (APA or authority)revenue bond ratings to Aa1 from Aa2. As of FY16, APA had approximately $38.7 million ofparity Series 2001 and Series 2014 revenue bonds outstanding. The rating outlook is stable.

An important consideration in APA's upgrade to Aa1 is the new take-or-pay power salescontractual structure that will become effective in October 2017, which reduces hydrologyand demand risk borne by APA relative to the former take-and-pay structure. In addition, thecontracts have been extended to 2067 and now provide increased customer diversity giventhe addition of 35 new wholesale customers. The Aa1 rating also considers the authority'sstrategic position as the sole entity responsible for acquiring and marketing Arizona’sallocation of power generated from the Hoover Dam, in addition to the low cost structurethat results from the Hoover Dam's unique hydroelectric system. The rating additionallyreflects the authority’s strong rate-setting record, including its new target to set rates tomeet a 1.25x debt service coverage ratio (DSCR), coupled with APA's consistent financialperformance, which has been demonstrated despite persistent drought conditions in theColorado River Basin over the last decade. The Aa1 rating further considers the outstandingdebt’s 2045 maturity date, which is well before the October 2067 termination date for APA’scurrent agreements for the purchase, sale, transmission and scheduling of power produced bythe Hoover Dam (Hoover Power), which has been formally confirmed by the Western AreaPower Administration (WAPA), the federal agency tasked with marketing Hoover Power.

Further, the rating acknowledges the high likelihood that the authority can find willingbuyers of its competitively priced power in the unlikely event that any member of APA’sdiverse group of 63 wholesale customers fail to honor the take-or-pay contracts, whichare anchored by highly-rated off-takers Arizona's Salt River Agricultural Improvement andPower District(SRP, Aa1 stable) and Central Arizona Water Conservation District (CAWCD,Aa2 stable). Collectively, SRP and CAWCD will constitute roughly half of APA’s wholesalecustomer take-or-pay demand allocation obligation once the new contracts becomeeffective in October 2017. The rating incorporates our view that SRP will likely purchaseany excess Hoover Power made available, which SRP has done historically. Additionally,the rating recognizes the authority’s debt leverage position, as measured by Moody's debtratio, is overstated as APA’s financial statements do not currently account for the value ofAPA’s roughly 19% entitlement to Hoover Power as a capital asset, along with the marketvalue of this resource. Also, the rating considers Hoover’s quick ramp-up capability, which isbecoming increasingly valuable in light of the growing intermittency in the southwest power

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marketplace, which is driven by base load plant retirements and increasing intermittent renewable generation capacity.

Exhibit 1

Despite drought conditions that have persisted in the Colorado River Basin over the last decade, generation has been relatively stable

-

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

201520142013201220112010200920082007200620052004200320022001200019991998199719961995199419931992199119901989

Hoover Powerplant Net Generation (MWh)

Source: US Bureau of Reclamation, Moody's Investors Service

Credit Strengths

» The new take-or-pay contractual structure reduces hydrology and demand risk borne by APA relative to the former take-and-pay structure, and provides increased customer diversity given the addition of 35 new wholesale customers under the post-2017contracts

» APA’s entitlement to Hoover Power extends through 2067, 22 years after maturity of the outstanding debt

» Stable prospective financial performance, with DSCR targeted at around 1.25x, which is increased from the historical target of 1.10x

» Strength of the wholesale supply take-or-pay contracts that are buttressed by highly-rated participants SRP and CAWCD

» The Hoover Dam represents a strategic national asset with significant hydroelectric value to the southwest region

» Hoover Power is very favorably priced compared with regional spot market alternatives, even during persistent drought conditions

» Power sales contracts permit rates to be modified upon 24-hour notice

» Highly-rated SRP has historically purchased the bulk of excess Hoover Power that has been made available

» Hoover’s quick ramp-up capability (100 MWs per minute) is becoming increasingly valuable in light of growing intermittency in thesouthwest power marketplace, being driven by base load plant retirements, such as the announced 2019 retirement of the 2,250MW coal-fired Navajo Generating Station, and increasing intermittent renewable resources

Credit Challenges

» Drought conditions that have reduced water levels in Lake Mead could impact the plant’s ability to produce power, though recentcapital improvements have resulted in additional operating flexibility

» General customer concentration in Arizona irrigation and water conservation districts could impact the authority during a stressedenvironment for the agribusiness sector

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 27 June 2017 Arizona Power Authority: Update - Moody's upgrades Arizona Power Authority's Revenue Bonds to Aa1 from Aa2; outlook stable


Rating OutlookThe outlook for APA is stable, reflecting the authority’s success in re-contracting for the purchase, sale, transmission and scheduling, viathe recently signed take-or-pay contracts with 63 participants that go into effect in October 2017, of its Hoover Power allocation until2067. The stable outlook also incorporates our assumption that the authority will maintain steady financial performance, consistentwith its historical track record, while continuing to provide competitively priced power to its customers.

Factors that Could Lead to an Upgrade

» In light of the upgrade to Aa1, limited prospects exists for further upward rating pressure.

Factors that Could Lead to a Downgrade

» Severe curtailment of Hoover hydroelectric production due to drought or other conditions

» A fundamental downturn in the Arizona agribusiness sector

» Narrowing liquidity levels or debt service coverage ratio levels due to an inability or unwillingness to raise rates in a timely manner

» Decline in the credit quality of either SRP or CAWCD

» Material increase in leverage or the price of Hoover Power

Key Indicators

Exhibit 2

Key Indicators

ARIZONA POWER AUTHORITY

2012 2013 2014 2015 2016

Debt Outstanding ($'000) 32,945 28,135 49,635 44,305 38,690

Debt Ratio (%) 209.8 172.3 111.9 100.9 87.8

Total Days Cash on Hand (days) 189 239 234 107 270

Adjusted Debt Service Coverage (x) (Post Transfers/PILOTs - All Debt) 1.05 1.09 1.02 1.10 1.44

Adjusted Debt Service Coverage was materially higher in 2016 on an accrual basis, relative to prior years, given that higher levels of advances for the Hoover uprating capital programwere reimbursed through Western credits on the authority's power bills. Given these advances have been recurring over the last 5 years, Moody's has historically classified these advancesas operating revenue from APA's normal operations, which are includable in net revenues. Additionally, we adjusted the deferred outflow line item present value of the future benefit ofreduced power rates that APA began reporting on the balance sheet in FY14 as a result of the Hoover Prepayment Project, as an amortizable capital asset in order to recognize the presentvalue of the reduced power rates APA will accrue going forward in the form of discounted power from WAPA.Source: Arizona Power Authority Financial Statements, Moody's Investors Service

Recent DevelopmentsOn October 1st 2017, APA's new take-or-pay contracts with 63 customers, which expire in 2067, will go into effect.

Detailed Rating ConsiderationsRevenue Generating BaseAs a not-for-profit wholesale electricity supplier, APA is able to pass along the benefits of Arizona's low-cost Hoover Power allocationto its wholesale contract customers, which will transition to take-or-pay contract customers from take-and-pay beginning in October2017. Moody’s views this contractual structure change to be a credit positive given the reduction in hydrology and demand risk borneby APA, in addition to the increased customer diversity provided by the additional 35 wholesale customers under the post-2017contracts. While the majority of the authority’s post-2017 customers are a variety of relatively small, unrated Arizona irrigationdistricts and municipal utilities, all of the customers have the ability to raise revenues on an unregulated basis. Moreover, APA's toptwo customers for Hoover Power on a GWh-sold energy basis, and going forward on both a GWh-sold energy basis and take-or-paydemand allocation basis, are CAWCD and SRP, each Aa-rated counterparties. CAWCD currently represents the authority's largestHoover Power customer, and will remain the largest customer by both a take-or-pay demand allocation obligation and GWh-soldenergy basis, under the new contracts. Combined, SRP and CAWCD will account for close to one-half of the take-or-pay demand



allocation obligation once the new contracts become effective in October 2017. Currently, SRP and CAWCD collectively account forclose to one-third of all the Hoover Power delivered by the authority.

While the number of customers will increase to 63 from 28 under the new contracts, in addition to SRP and CAWCD's collective shareof the ultimate payment obligation rising from roughly one-third to one-half, APA’s customer base will still be somewhat concentratedin the Arizona agribusiness industry. This agribusiness concentration, coupled with the industry's peculiar vulnerabilities, contribute tothe potential for demand volatility. Annual agricultural sector electric power demand is shaped to a large extent by variable factorssuch as crop patterns, planted acreage, surface water availability, in addition to economic factors such as commodity prices. Despitethe potential for demand volatility, we believe these risks are largely mitigated by the new take-or-pay contractual structure thatprovides APA with material cost recovery protection. Moreover, power from the authority generally represents APA's customers' lowestpower cost option as evidenced by the fact that APA has historically had little problem finding willing buyers of Hoover Power whileoperating under the take-and-pay contractual framework. In fact, SRP has historically purchased the bulk of any excess power that hasbeen made available and Moody's believes this would continue to be the case should any customers become unable to meet their take-or-pay contractual obligation.

The Hoover contractors, which includes APA along with various other California and Nevada entities that have been granted anallocation of Hoover Power, must sell power on a not-for-profit basis. As a result, and considering that rain water is free, APA'scustomers benefit from what is generally the lowest cost source of power available to them. For FY14-16, the average total all-in costof Hoover Power, which provides the majority of its output during peak periods, delivered to APA customers was just over $30.00/MWh. Excluding the cost of transmission, but including general and administrative expenses, the price averaged under $20.00/MWhduring FY14-16. Over the same period, the average peak price for electricity at the Palo Verde pricing hub was approximately $30.00/MWh.

Operational and Financial PerformanceHistorically, APA's management and board have been effective at keeping the authority's operating costs in check, while frequentlyrevisiting the rates charged to customers to ensure the adequate recovery of total costs. Moody's views the authority's ability andcapacity to pass-through cost increases on a monthly basis as a positive credit factor, especially since only a minimum 24-hournotice is required for any rate changes, in the most extreme scenario. On average over the past five years, the authority's energyrates for Hoover Power have risen just under 10% annually (1.4% in April 2013, 5.6% in June 2015, 7.6% in August 2015 and 34.9%in September 2015), with robust increases occurring in 2015. That said, in light of APA's strong rate-setting record, Moody's takes apositive view on the authority's willingness to proactively manage rates to maintain stable financial performance.

Due to APA's not-for-profit nature, its debt service coverage ratio is intentionally kept at a minimum. Once the new contracts go intoeffect in October 2017, the authority will prospectively target DSCR of 1.25x, an increase from the current annual target of 1.10x anda credit positive. Excess annual revenues earned in any operating year are credited back to the authority's customers in the followingoperating year, which along with all capital costs directly included in the monthly billing cycle, decreases APA's need to have high debtservice coverage. Moody's calculated APA FY14-16 three-year average net revenue DSCR at 1.18x. We note that APA’s FY16 adjustedDSCR of 1.44x was higher than prior fiscal years, which has historically ranged from between 1.0x-1.10x, as higher levels of advancesfor the Hoover uprating capital program were reimbursed in FY16 through WAPA credits on the authority's power bills. Since theseadvances have recurred over the last 5 years, but end in FY17, Moody's has historically classified these advances as operating revenuefrom APA's normal operations, which are includable in net revenues. APA's unique, low-cost, low-risk business profile and strong cashposition serve to offset APA's otherwise consistently weak debt service coverage metric.

The authority has had a scheduling entity agreement in place with SRP since early 2000. This scheduling entity agreement hassupported APA's top-line revenues while simplifying the planning and scheduling needs of its customers, in addition to providing SRPwith a dynamic balancing resource. The current agreement, which SRP has paid APA $5.45 million annually for Hoover's ancillaryservices benefits, expires September 30, 2017. Ancillary services help balance the transmission system as it moves electricity fromgenerating sources to ultimate consumers, and becomes more important as intermittency increases. The post-2017 contract customerswill be able to elect to sell their ancillary services (dynamic signal) themselves, and both SRP and CAWCD will likely utilize theirdynamic signal post-2017, which should reduce their all-in Hoover Power cost. APA anticipates the cost of Hoover Power, inclusive ofgeneral and administrative costs but before transmission costs, will range from $25 to $30 per MWh over the next few years, which



is likely to be reduced by ancillary service revenue. In any case, Moody's expects Hoover Power will remain an attractive resourcecompared with available alternatives.

LIQUIDITYAs measured by days cash on hand, Moody's considers the authority's liquidity position to be strong. At APA's September 2016 fiscalyear-end, the authority had 270 days cash on hand, and a FY14-16 three-year average days cash on hand metric of 204 days. Theauthority's cash balance could be impaired if any Hoover disruptions, which result in material power cost increases above APA's currentprojections, were not able to be recovered on a timely basis through rate increases. Moody's anticipates the authority will activelymanage its liquidity in a manner consistent with its stated goal of maintaining stable Hoover Power costs.

Debt and Other LiabilitiesAPA currently has roughly $38.7 million of debt outstanding across the parity Series 2001 and Series 2014 revenue bonds. The Series2001 bonds, which are coterminous with the existing power sales contracts, will mature on October 1, 2017. The authority, whosecapital costs are included in monthly customer power bills, does not anticipate any major capital needs or debt issuance in theforeseeable future.

APA's debt ratio, which Moody's calculates as total debt minus reserves as a percentage of total depreciated capital assets plus workingcapital, had a FY14-16 three-year average slightly over 100%. We note, however, that this ratio is not particularly instructive as theauthority's primary asset, its entitlement to power from the Hoover Dam, does not appear on APA's balance sheet. APA is currentlyworking with the Arizona state auditor to evaluate revising the APA balance sheet to reflect the asset value of the contracts, whichwould have the effect of significantly lowering APA's debt ratio. Should this value be reflected on APA’s balance sheet as a capitalasset, Moody’s believes this sub-factor in the methodology would comfortably score in the Aa category. While this is currently notincorporated in the financial statements, we recognize the value of the resource from a balance perspective and the positive implact onAPA's credit profile, outside of the scope of the scorecard.

DEBT STRUCTUREThe authority's debt structure is fixed rate, with a level debt service schedule for most of the life of the bonds. The Series 2014 revenuebonds mature in 2045 and annual debt service requirements compose roughly $1.8 million, beginning in 2018 and concluding atmaturity.

DEBT-RELATED DERIVATIVESNone.

PENSIONS AND OPEBThe authority contributes to the Arizona State Retirement System (ASRS), which administers a cost-sharing, multiple-employer definedbenefit pension plan. At fiscal year-end 2016, APA's proportional net pension liability was $0.923 million. Based on our calculations, theauthority's Adjusted Net Pension Liability (ANPL) was $2.1 million in fiscal year 2016.

Management and GovernanceThe authority is run by a 5 commissioner board. Each commissioner is appointed by the Arizona governor to serve 6 year non-concurrent terms. The commission determines rate adjustments without any other approval process, and monitors revenuerequirements on a monthly basis.

Legal SecurityThe authority's outstanding bonds are payable solely from net revenues derived from APA's sale of power generated by the Hooverpower plant. Post-October 1st 2017, those sales will be made under take-or-pay power sales contracts (which are authorized underArizona law) with 63 Arizona irrigation districts and municipal utilities, which will constitute APA’s contract customers until contractexpiration in 2067. The revenue pledge extends to replacement contracts as well as any other revenue generated from the sale ofHoover Power. APA has a sum-sufficient (1.0 times) rate covenant, a cash funded debt service reserve fund equal to maximum annualdebt service and an additional bonds test of one times historical (12 out of the past 24 months) and future (five years) debt servicecoverage.



APA's obligation to pay WAPA for the costs associated with the Hoover Dam is generally on a take-or-pay basis. In the event therevenues generated by WAPA's sale of power was insufficient to cover the federal Bureau of Reclamation's costs of operating the dam,APA and the other Hoover contractors would remain obligated to pay their proportionate share of these costs. This risk is mitigated bythe engineering and construction of the dam, which includes 17 separate generation units relying on the natural flow of water throughthe Colorado River basin for the production of power. The Hoover Dam power plant has been in continuous operation since the firstgenerating units were installed over 80 years ago.

Use of ProceedsNot applicable.

Obligor ProfileArizona Power Authority is a state agency responsible for the acquisition and marketing of Arizona's approximate 19% share of theelectrical output from the federally owned and operated Hoover Dam power plant. The authority has been acting in this capacitysince 1952. The Hoover Power Allocation Act of 2011 extended APA's entitlement to capacity and energy produced by Hoover throughSeptember 2067. APA is a not-for-profit entity with no taxing authority, however per state statutes, APA is required to set rates at levelssufficient to recover its total costs.

Issuer ContactEd Gerak, Executive Director, [email protected]

Other Considerations - Mapping to the GridThe grid is a reference tool that can be used to approximate credit profiles in the industry in most cases. However, the grid is asummary that does not include every rating consideration. Please see US Public Power Electric Utilities With Generation OwnershipExposure for information about the limitations inherent to the grid.

Moody's evaluates APA relative to the rating methodology for U.S Public Power Electric Utilities with Generation Ownership Exposureand, as depicted below, the APA scorecard indicated rating is Aa2, one notch below APA's Aa1 rating. This difference reflect APA's debtratio which is overstated from an accounting perspective as the authority's primary asset, its entitlement to power from the HooverDam, does not appear on APA's balance sheet. Should this value be reflected on APA’s balance sheet as a capital asset, Moody’s believesthis sub-factor in the methodology would comfortably score in the Aa category.



Exhibit 3

APA Methodology Grid

Factor Subfactor Score Metric

1. Cost Recovery Framework Within Service Territory Aaa

2. Wllingness and Ability to Recover Costs with Sound Financial

Metrics

Aaa

3. Generation and Power Procurement Risk Exposure Aa

4. Competitiveness Rate Competitiveness Aa

5. Financial Strength and Liquidity a) Adjusted days liquidity on hand (3-year

avg) (days)

Aa 204

b) Debt ratio (3-year avg) (%) B 100.2%

c) Adjusted Debt Service Coverage or Fixed

Obligation Charge Coverage (3-year avg) (x)

Baa 1.18

Preliminary Grid Indicated rat ing from Grid factors 1-5

Notch

6. Operational Considerations 0

7. Debt Structure and Reserves 0

8. Revenue Stability and Diversity 1

Grid Indicated Rating: Aa2

Ratios based on credit metrics for the 3-year average period from 2014 to 2016.Source: Moody's Investors Service

MethodologyThe principal methodology used in this rating was US Public Power Electric Utilities With Generation Ownership Exposure published inMarch 2016. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.



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arizona power authority · 6/27/2017 · and demand risk borne by apa relative to the former...

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