Credit Opinion: Duke Energy Corporation

Transcription

1 Credit Opinion: Duke Energy Corporation Global Credit Research - 29 Mar 2012 Charlotte, North Carolina, United States Ratings Category Moody's Rating Outlook Stable Issuer Rating Baa2 Sr Unsec Bank Credit Facility Baa2 Senior Unsecured Baa2 Subordinate Shelf (P)Baa2 Commercial Paper P-2 Duke Energy Carolinas, LLC Outlook Stable Issuer Rating A3 First Mortgage Bonds A1 Senior Secured MTN (P)A1 Senior Unsecured A3 Subordinate Shelf (P)Baa1 Duke Energy Indiana, Inc. Outlook Stable Issuer Rating Baa1 First Mortgage Bonds A2 Senior Secured A2 Senior Unsecured Baa1 Jr Subordinate Shelf (P)Baa2 Contacts Analyst Phone Michael G. Haggarty/New York City William L. Hess/New York City Key Indicators [1]Duke Energy Corporation (CFO Pre-W/C + Interest) / Interest Expense 4.7x 4.8x 5.2x 5.2x (CFO Pre-W/C) / Debt 18.0% 20.9% 22.5% 23.2% (CFO Pre-W/C - Dividends) / Debt 11.8% 14.2% 15.8% 16.6% Debt / Book Capitalization 41.8% 39.6% 40.4% 39.6% [1] All ratios calculated in accordance with the Global Regulated Electric Utilities Rating Methodology using Moody's standard adjustments. Note: For definitions of Moody's most common ratio terms please see the accompanying User's Guide. Opinion

2 Rating Drivers - Merger with Progress Energy is credit neutral, but would improve longer-term strategic position - Success of merger is dependent on FERC and state approval of second market mitigation plan in the Carolinas - Some regulatory risk in Indiana with IGCC cost recovery proceedings but generally supportive regulatory environments - Longer-term uncertainty at Duke Ohio as it transfers its generating assets to an affiliate or subsidiary - Coal fired generation will require significant environmental compliance expenditures - Percentage of parent holding company debt will increase following merger Corporate Profile Duke Energy Corporation (Duke: Baa2 senior unsecured, stable outlook) is one of the largest electric utility holding companies in the U.S., with service territories in the Carolinas, Indiana and portions of Ohio and Kentucky. Duke owns approximately 29,700 MW's of regulated electric generation facilities, a substantial amount of which are coalfired. Duke also maintains a sizeable non-regulated investment portfolio, which includes operations in Latin America and some renewable wind-powered projects in the U.S. Duke is headquartered in Charlotte, North Carolina. On January 10, 2011, Duke announced a merger with regulated utility system Progress Energy Corporation (Progress). The merger has received several of the required regulatory approvals, including conditional approval of the Federal Energy Regulatory Commission (FERC), although final FERC approval is dependent on its acceptance of a second market mitigation plan proposed by the companies in the Carolinas. The companies' initial proposal to "virtually divest" some plants was rejected by the FERC as insufficient, delaying the closing of the merger by at least six months. On March 26, 2012, the companies filed a new market mitigation plan with the FERC that proposes a combination of permanent transmission projects and interim power sales. Duke and Progress hope to receive an order approving the mitigation plan by mid to late May, and no later than June 8, Moody's affirmed the Baa2 senior unsecured ratings and stable rating outlooks of both Duke and Progress, as well as the ratings of their operating utility subsidiaries, at the time of the merger announcement. SUMMARY RATING RATIONALE Duke's rating reflects the company's large, mostly rate-regulated utility operations in multiple jurisdictions, a financial profile that has been strong for its rating, and generally supportive regulatory frameworks in the states in which it operates. However, the company faces some regulatory risk with regard to ongoing Edwardsport Integrated Gasification Combined Cycle (IGCC) plant cost recovery proceedings in Indiana. As one of the largest coal fired utilities in the U.S., the company also faces higher capital expenditures related to EPA mandated environmental compliance requirements. DETAILED RATING CONSIDERATIONS - Merger with Progress Energy is credit neutral, but would improve longer-term strategic position Duke has been viewed in recent years as strongly positioned within its Baa2 senior unsecured rating category; although following its merger with Progress Energy, it will be viewed as more appropriately positioned. The merger will combine Duke with the more weakly positioned Baa2 rated Progress Energy holding company, where the rating has long been constrained by $4 billion of debt at the parent company level. The merger will create the largest electric utility holding company in the U.S. and increase the already high proportion of revenues, earnings, and cash flows that come from rate-regulated electric utility operations, a credit positive. Although the percentage of Duke's lower risk regulated business activities should increase to roughly 85% of its total business from 75% today, the combined company's key cash flow to debt metrics are expected to fall to the 15% to 16% range from 20% or higher currently, but will still be considered adequate for its Baa2 rating. Because of their relatively similar credit profiles, the Baa2 ratings of both Duke and Progress were affirmed with stable outlooks at the time of the merger announcement, as were the ratings of each company's rated subsidiaries. The rating affirmations also reflected the longer-term strategic benefits of the merger, including the addition of a Florida territory, generation dispatch efficiencies in the Carolinas, and the ability to spread fixed costs over a larger asset platform.

3 over a larger asset platform. A larger Duke/Progress organization will also be better positioned to undertake the construction of new nuclear generation in either the Carolinas or Florida in the event the company decides to move forward in this direction. In July 2011, Duke Energy Carolinas signed a letter of intent to explore the option of acquiring a potential 5% to 10% minority interest in Santee Cooper's ownership share of new nuclear reactors at the V.C. Summer Nuclear Generating Station in South Carolina. Duke Carolinas also received authorization from both the North Carolina and the South Carolina Regulatory Commissions to spend an additional $120 million through June 2012 for development activities related to a potential new nuclear generation plant at the proposed Lee Nuclear Station site in Cherokee County, South Carolina. - Merger success depends on approval of second market mitigation plan in the Carolinas Although the merger has received several required regulatory approvals, FERC's final approval is conditional on its acceptance of a market power mitigation plan in the Carolinas. The companies' first market mitigation plan to "virtually divest" some power plants was rejected by the FERC as inadequate in December 2011, delaying the merger closing by about six months while a second plan was prepared. The companies recently filed a second market power mitigation plan with the North Carolina Utilities Commission (NCUC) and the FERC. The revised plan has Duke and Progress constructing seven transmission projects in their service territories, which will expand the capability to import wholesale power into the Carolinas. The projects will cost $110 million and are expected to take two to three years to complete. In the interim, the companies will sell capacity and firm energy during the summer and winter to other market participants. - Some regulatory risk in Indiana with regard to IGCC plant cost recovery proceedings but generally supportive regulatory environments Despite receiving relatively supportive regulatory outcomes in three jurisdictions in 2011, some regulatory risk remains relating to two regulatory proceedings at Duke Indiana on the substantial cost overruns that were incurred during the construction of its 618-MW Edwardsport IGCC plant, which was 97% complete as of December 31, The first proceeding (Phase I) requests approval for the company to recover $530 million of cost increases above the $2.35 billion cost cap that has been already approved by the Indiana Commission. The second proceeding (Phase II) involves testimony from the Indiana Office of Utility Consumer Counselor (OUCC) and intervenors that alleges the company concealed information and grossly mismanaged the project with a recommendation that cost recovery be limited to the original approved project cost of $1.985 billion. The outcome of these two regulatory proceedings are important in that they will determine the degree to which the company can recover the nearly $1 billion of the IGCC project cost overruns incurred. On October 19, 2011, the company again revised its cost estimate for Edwardsport upward to $2.98 billion (excluding financing costs of approximately $300 million) from $2.72 billion. As the company had previously proposed a cost cap of $2.72 billion to the Indiana Utility Regulatory Commission (IURC), the company took a pretax impairment charge of $222 million in the third quarter of 2011 because recovery of these additional costs was considered unlikely. The company has indicated that the most recent cost overruns were related to unfavorable labor productivity trends and incremental material quantity and scope changes. Duke Carolinas recently settled two rate cases in North and South Carolina with relatively credit supportive outcomes. The November 22, 2011 settlement agreement with the NCUC Staff allowed for a $369 million or 8.6% increase in base rates (approximately 57% of the original base rate increase requested), with a return on equity of 10.5% and a 53% equity component in the capital structure. The December 7, 2011 revised settlement with the South Carolina Office of Regulatory Staff allows for an increase in base rates of approximately $92.8 million or 6% (43% of the originally requested $216 million total), with a return on equity of 10.5% and a 53% equity component. Although both settlements, particularly in South Carolina, resulted in significantly lower rate adjustments than the approximately 15% increases that had been requested by the company, this is understandable given the current lingering recessionary conditions still in evidence in the Carolinas. The awarded return on equity in both states was only slightly below the 10.7% return on equity previously in place, and well above some of the ROE's proposed by several intervenors in the case. The company expects to file new rate cases in both states in 2012 as it completes the construction of its Cliffside 6 coal and Dan River gas generating plants. - Longer-term uncertainty in Ohio as Duke Ohio transfers it generating assets to an affiliate or subsidiary On November 22, 2011, the Public Utilities Commission of Ohio (PUCO) approved a new Electric Security Plan (ESP) for Duke Ohio that replaced the company's previous ESP that expired on December 31, The new

4 (ESP) for Duke Ohio that replaced the company's previous ESP that expired on December 31, The new ESP requires the utility's generation requirements to be procured through a competitive bid process, with customer rates now based on these fully competitive auctions. The ESP includes a retail capacity rider (Rider RC) and a retail energy rider (Rider RE) which are bypassable for those electric customers who have switched suppliers. It also includes a non-bypassable electric service stability charge (Rider ESSC) of $110 million per year or $330 million in total. As part of the ESP, Duke is required to transfer its non-regulated generating assets at book value to an affiliate or subsidiary by the end of 2014, providing strategic flexibility but raising longer-term uncertainty. The earlier rejection of the company's Market Rate Offer (MRO) proposal and the approval of the new ESP continues the state of Ohio's steady movement away from a regulated and toward a more competitive market for generation in the state. Because of continued low power prices, declining capacity prices, and lingering recessionary conditions in the region, we expect Duke Ohio's revenues, earnings, and cash flow from the generation portion of its business to decline under the new ESP. The inclusion of $330 million of Rider ESSC revenues will partially offset these lower results, as will cash flow from the company's transmission and distribution business, which remains fully regulated. - Coal fired generation will require significant environmental compliance expenditures In 2011, 60% of the energy generated by Duke's U.S. Franchised Electric and Gas business segment came from coal. As one of the largest coal-fired utility systems in the U.S., the company is vulnerable to additional costs associated with new EPA environmental compliance regulations. Duke expects to spend a total of approximately $5 billion through 2020 to comply with Cross-state Air Pollution Rule (CSAPR), Utility MATS, and other pending regulations such as coal ash and water intake. Following its merger with Progress Energy, Duke will be somewhat better positioned to manage these environmental costs, as Progress has a lower coal concentrated generation portfolio, making the post-merger Duke organization more diversified from a generation standpoint. - Percentage of parent holding company debt will increase following merger Approximately 19% of Duke's total consolidated debt outstanding is at the parent holding company, while Progress Energy has approximately 30% of its total debt at the parent company. On a pro-forma combined basis following the merger, parent company debt as a percentage of total debt will likely be in the range of 25%, which will continue to merit a two notch differential between the rating of the Duke parent company at Baa2 and its largest postmerger utility subsidiaries, Duke Energy Carolinas and Progress Energy Carolinas, at A3. Liquidity Profile Duke maintains an adequate liquidity profile, with a manageable amount of long-term debt due over the 12 months ending March 31, 2013 and a new $6 billion, five-year master bank credit facility in place at the parent company, which includes sublimits for each of its major utilities. The facility was structured to accommodate the Progress merger, with $2 billion of the total amount being held in escrow until the merger closes, and $4 billion currently available. The facility matures on November 18, 2016, does not contain a material adverse change clause for new borrowings, and contains a single financial covenant, requiring that Duke and its four utility subsidiaries maintain a consolidated debt to capitalization ratio of no more that 65%. At December 31, 2011, each company was in compliance with this financial covenant. The facility includes borrowing sublimits of $1.25 billion each for Duke Energy and Duke Energy Carolinas, $700 million for Duke Energy Ohio, $700 million for Duke Energy Indiana, and $100 million for Duke Energy Kentucky as of December 31, Duke had $3.1 billion available under this credit facility as of December 31, The facility currently supports $525 million of outstanding commercial paper, $260 million of tax-exempt bonds, and $85 million of letters of credit. Duke also maintains a money pool arrangement among its utility subsidiaries allowing it to more efficiently utilize available cash balances throughout the organization. As of December 31, 2011, Duke had approximately $2.3 billion of cash and short-term investments on hand, up from the $1.7 billion on hand at year end Approximately $1 billion of this cash is held offshore in Duke's international businesses, some of which may not be quickly and readily available for liquidity purposes. The company's scheduled debt maturities over the next 12 months include approximately $1.1 billion of which about $400 million is at its Duke Carolinas subsidiary and about $500 million at Duke Ohio. Both subsidiaries expect to satisfy the obligations with proceeds from additional borrowings. For 2011, Duke produced roughly $3.7 billion of cash flow from operations (CFO), on a Moody's adjusted basis, invested $4.3 billion, and paid $1.3 billion in common dividends, resulting in $1.9 billion of negative free cash flow (FCF). We expect the company to continue to generate substantial negative FCF over the next few years, which will be funded primarily through the issuance of incremental debt.

5 will be funded primarily through the issuance of incremental debt. Rating Outlook The rating outlook of Duke is stable, reflecting the relatively low business risk profile of its predominantly regulated utility business, generally credit supportive regulatory environments, and Moody's expectation that cost recovery proceedings in Indiana and utility restructuring in Ohio will be resolved without materially affecting credit quality. It also incorporates our view that the pending merger with Progress Energy will be largely credit neutral, resulting in a larger, more resilient, and more diverse organization. What Could Change the Rating - Up A rating upgrade is unlikely over the near-term while the Progress Energy merger is pending, while there are regulatory proceedings underway in Indiana and longer-term structural questions in Ohio. Nevertheless, Duke's rating could be upgraded if it successfully completes the merger, obtains regulatory clarity in Indiana and structural certainty in Ohio, and can generate CFO pre-w/c to debt ratio in the mid to high teens on a sustained basis. What Could Change the Rating - Down Ratings could become pressured if there are adverse regulatory outcomes at any of its major utilities, including with regard to cost recovery proceedings in Indiana, resulting in a downgrade of one or more of its utility subsidiaries. Ratings could also be downgraded if Duke issues significant additional debt at the parent company or if its consolidated financial profile were to deteriorate, including generation of a CFO pre-w/c to debt ratio in the low teens on a sustained basis. Rating Factors Duke Energy Corporation Regulated Electric and Gas Utilities Industry [1][2] FY 12/31/2011 Moody's month Forward View* As of March 2012 Factor 1: Regulatory Framework (25%) Measure Score Measure Score a) Regulatory Framework Baa Baa Factor 2: Ability To Recover Costs And Earn Returns (25%) a) Ability To Recover Costs And Earn Returns A A Factor 3: Diversification (10%) a) Market Position (5%) A A b) Generation and Fuel Diversity (5%) Ba Ba Factor 4: Financial Strength, Liquidity And Key Financial Metrics (40%) a) Liquidity (10%) Baa Baa b) CFO pre-wc + Interest/ Interest (3 Year Avg) (7.5%) 4.9x A 4.5x - A 5.0x c) CFO pre-wc / Debt (3 Year Avg) (7.5%) 20.4% Baa 18% - Baa 22% d) CFO pre-wc - Dividends / Debt (3 Year Avg) (7.5%) 13.8% Baa 13% - Baa 17% e) Debt/Capitalization (3 Year Avg) (7.5%) 40.6% A 40% - A 45% Rating: a) Indicated Rating from Grid Baa1 Baa1

6 b) Actual Rating Assigned Baa2 Baa2 * THIS REPRESENTS MOODY'S FORWARD VIEW; NOT THE VIEW OF THE ISSUER; AND UNLESS NOTED IN THE TEXT DOES NOT INCORPORATE SIGNIFICANT ACQUISITIONS OR DIVESTITURES [1] All ratios are calculated using Moody's Standard Adjustments. [2] As of 12/31/2011(LTM); Source: Moody's Financial Metrics 2012 Moody's Investors Service, Inc. and/or its licensors and affiliates (collectively, "MOODY'S"). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. ("MIS") AND ITS AFFILIATES ARE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODY'S ("MOODY'S PUBLICATIONS") MAY INCLUDE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY'S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS AND MOODY'S OPINIONS INCLUDED IN MOODY'S PUBLICATIONS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL FACT. CREDIT RATINGS AND MOODY'S PUBLICATIONS DO NOT CONSTITUTE OR PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODY'S PUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES. NEITHER CREDIT RATINGS NOR MOODY'S PUBLICATIONS COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MOODY'S ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODY'S PUBLICATIONS WITH THE EXPECTATION AND UNDERSTANDING THAT EACH INVESTOR WILL MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO, COPYRIGHT LAW, AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY'S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY'S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided "AS IS" without warranty of any kind. MOODY'S adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources Moody's considers to be reliable, including, when appropriate, independent third-party sources. However, MOODY'S is not an auditor and cannot in every instance independently verify or validate information received in the rating process. Under no circumstances shall MOODY'S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY'S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY'S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. Each user of the information contained herein must make its own study and evaluation of each security it may consider purchasing, holding or selling. NO WARRANTY, EXPRESS

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