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2023-054 Fitch Ratings August 18, 2023 Report No. 2023-054 INFORMAL STAFF REPORT TO MAYOR AND CITY COUNCIL SUBJECT: Fitch Ratings annual rating review of Utility System revenue bonds BACKGROUND: The purpose of this report is to provide City Council notice of the annual bond credit rating from Fitch Ratings (Fitch) for the City's Utility System revenue bonds. During July and August, staff and the City's financial advisor, Hilltop Securities Inc., participated in discussion with analysts from Fitch providing data regarding the City's financials and Utility System including updated budget and capital improvement project forecasts. As a result,Fitch affirmed the rating of`A' and revised the outlook to Stable. DISCUSSION: Fitch has affirmed the 'A' rating to the Utility System revenue bonds. This affirmation reflects Denton's very strong revenue defensibility assessment and strong operating risk profile,which considers a still low- cost burden and weaker operating flexibility assessment. The rating also considers the expectation that the system's leverage will remain above pre-Storm Uri levels as a result of anticipated debt financing to fund planned capital expenditures. The affirmed Stable outlook reflects the utility's financial profile to remain supportive of the rating, even incorporating the additional planned debt issuances, as well as an expected increase in retail sales associated with a large customer, Core Scientific, significant water system expansion and rate increases. The `A' rating continues to classify the Utility System debt as "Investment Grade". For your review, the Fitch rating report and a ratings definition chart is attached. ATTACHMENTS: 1. Fitch 2023 Utility System Revenue Bonds Rating 2. Fitch Rating Definitions STAFF CONTACT: Randee Klingele, Treasury Manager (940)-349-8206 Randee.Klingele(&,cityofdenton.com 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable FitchRatings RATING ACTION COMMENTARY Fitch Affirms Denton, TX's Utility System Rev Bonds at 'A'; Outlook Stable Wed 09 Aug,2023- 5:18 PM ET Fitch Ratings-Austin - 09 Aug 2023: Fitch Ratings has affirmed the'A' rating on the following bonds issued by the City of Denton,TX on behalf of its combined utility system: --$333.0 million utility system revenue bonds,series 2017 and utility system revenue refunding bonds,taxable series 2021. In addition, Fitch assesses the standalone credit profile(SCP) of the City of Denton utility system at 'a'.The SCP represents the credit profile of the utility on a standalone basis, irrespective of its relationship with the related credit quality of the city of Denton (AA+/Stable). The Rating Outlook is Stable. RATING ACTIONS ENTITY/DEBT RATING PRIOR Denton (TX) [Electric] Denton (TX)/Utility A Rating LT A Rating Outlook Stable Affirmed System Revenues/1 Outlook LT Stable VIEW ADDITIONAL RATING DETAILS https://w,&w.fitchratings.com/research/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 1/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable The'A' rating and 'a' SCP reflect Denton's very strong revenue defensibility assessment and strong operating risk profile,which considers a still low-cost burden and a weaker operating flexibility assessment.The rating also considers Fitch's expectation that the system's leverage will remain above pre-Storm Uri levels as a result of anticipated debt financings to fund planned capital expenditures. Denton's five-year capital improvement plan (CI P) through 2027 totals$1.2 billion,which is a roughly 55% increase from the utility's previous 2022-2026 CI P.The upsizing includes sizable growth in the utility's water and wastewater capital spending from planned service expansion to surrounding municipal utility districts.Current estimates indicate approximately 90%of the five-year CI P to be debt financed,which compounds the additional debt issued in 2021 to finance approximately$141 million in winter storm costs. The utility's financial profile is expected to remain supportive of the current rating, incorporating the additional planned debt issuances,as well as an expected increase in retail sales associated with a new large customer,Core Scientific,significant water system expansion and rate increases. Core Scientific is constructing a cryptocurrency mining operation in the city,which is expected to reach full operational capacity over the next several years.Core entered into a purchase power agreement(PPA)with Denton that enables it to recover full costs of purchasing power for Core Scientific on a timely basis,thereby limiting financial risk to other retail customers from the new load.Core Scientific has a net carbon-neutral goal that aligns with the Denton's Renewable Resource Plan (DRRP),adopted in 2018,and established a goal to provide 100% of retail energy supplies from renewable energy. Purchased power to serve the facility will be emissions-free power supplemented by renewable energy credits (RECs).Core Scientific entered chapter 11 bankruptcy protection in November 2022 and is expected to emerge in October 2023,maintaining their cryptocurrency mining operations to date. SECURITY The bonds are payable from the net revenues of the combined utility system,including the water,wastewater,and electric light and power systems. KEY RATING DRIVERS Revenue Defensibility- 'aa' Rapidly Growing Retail Municipal Utilitywith Rate Flexibility https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 2/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable Revenue defensibility is very strong and supported by combined retail electric,water and wastewater services to a growing service area in and around the city.The service area is characterized by very strong customer growth and a responsive rate structure with an adjustable component to recover actual power supply costs. Demand for services is supported by strong customer growth,averaging 3.1% over the past five years through 2022. Rate flexibility is very strong. Utility rates are determined independently by City Council and are not subject to third-party regulation. Electric distribution costs approximate that of the state and are highly affordable at 1.9% of median household income(MHI). Customer concentration increased in 2022 when Core Scientific began operations in the service area.Although Core Scientific represents a material amount of expected electric revenues beginning in fiscal 2023,the customer amounts to a substantially smaller portion of utility net margin.Fitch views the increased customer concentration introduced by the Core Scientific facility as an Asymmetric Credit Rating Consideration. However,it does not diminish the very strong revenue defensibility assessment since financial risk to the city is mitigated by the terms of the utility's agreement with Core Scientific. Operating Risk- 'a' Low Cost Burden;Weaker Operating Cost Flexibility; Increasing Capex Fitch assessed the operating risk profile and operating cost flexibility of public power utilities operating within the Electric Reliability Council of Texas (ERCOT) organized power market at 'a' and 'weaker',respectively,following the market dislocation experienced during Winter Storm Uri and the ongoing exposure to ERCOT market and counterparty risks. Fitch assesses Denton's operating cost burden as low with costs above 16 cents per kWh in 2022,which approximates the upper threshold for the assessment.Additionally,Fitch takes into consideration the extraordinarily high gas prices during 2022 as well as the moderation in prices already evident during 2023,which should lead to a trend of lower costs going forward.Denton's operating cost burden also reflects costs associated with Denton's DRRP and the city's achievement of its 100% renewable target in 2021. The operating risk assessment is constrained by Fitch's view of elevated risks associated with operating in the ERCOT market,including natural gas delivery,counterparty risk,and electric price volatility,all of which were exposed during the 2021 winter storm. https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 3/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable Increased capital spending is projected for all three utilities to aid growth in the service area and reinvest in aging utility infrastructure,especially for water and wastewater projects.A substantial 90%of the five-year CI Pis expected to be debt financed.Capital needs are manageable but are expected to result in leverage ratios remaining near current levels through the next five years. Financial Profile - 'a' Leverage to Increase from Capex Growth and Related Planned Debt Requirements Denton's leverage is elevated at 8.3x and 8.4x respectively in 2021 and 2022 compared to an average of 6.8x in the preceding three years after 2021 storm related costs were financed over 30 years and expanded capital spending required additional debt issuance. Fitch expects leverage to remain between 8x to 9x over the next five years in the base and stress scenarios,reflecting the utility's current forecast levels of capital spending,debt issuance and initially estimated rate growth across the three utilities,particularly in the water and wastewater utilities. The utility's leverage profile reflects the combined service lines,including the water and wastewater operations,which are able to support higher leverage than electric utilities.The water and wastewater utilities reflect the most significant growth and increased capital over the five-year planning horizon which reinforce the utility's ability to manage higher leverage. Liquidity is considered neutral to the rating.Coverage of fixed obligations (COFO) is also neutral to the rating,above 1.0x over the past five years. Asymmetric Additional Risk Considerations No asymmetric additional risk considerations affected the rating outcome. RATING SENSITIVITIES Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade --Regulatory changes that impose material new capex or operating costs for utilities; --Although unexpected,increased operating risk associated with providing power to the city's new large customer,Core Scientific; https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 4/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable --Weaker liquidity profile or leverage consistently above 10.Ox in Fitch's base or stress case reflecting rates that do not keep pace with system growth. Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade --Lower than expected capital spending,or increased pay-gofundingof the capital program could lower leverage from current anticipated levels to consistently below B.Ox in Fitch's base and stress case. BEST/WORST CASE RATING SCENARIO International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years.The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings,visit https://www.fitchratings.com/site/re/10111579. PROFILE The city of Denton,TX(AA+/Stable),is a high growth suburb located approximately 35 miles north of the cities of Dallas and Fort Worth.With a population of about 150,000, Denton is located at the northern end of the Dallas-Fort Worth (DFW) metro area.The city provides retail electric,water,and wastewater services through its municipally owned utilities.The electric system is the largest of the city's combined utilities and accounts for the majority of the revenues. Fitch considers the combined utility to be a related entity of the City of Denton,given the organization of those operations as enterprise funds of the city and the city's oversight, including budget and rate setting.The rating on the utility revenue bonds is not constrained by the credit quality of the city.However,as a result of being a related entity,the rating could become constrained in the event of a very material decline in the general credit quality of the city. February 2021 Winter Storm Event https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 5/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable Denton's net storm costs totaled approximately$141 million,allocable to the electric utility, which have been financed as long-term debt over 30 years.The costs include net energy service costs from ERCOT and natural gas suppliers incurred during the week of Feb. 14-19, 2021.The exponential prices spikes were prompted by unprecedented and prolonged below freezing temperatures across the state and the resulting ERCOT market dislocation,when over 30,000 MW of various fuel-type generation failed to deliver in the extreme conditions. Denton experienced outages at its own generation resources,curtailed gas delivery to the Denton Energy Center and a wind energy contract that failed to deliver,which collectively exposed the utility to market prices that reached and remained at the$9,000 per megawatt hour(MWh) ERCOT market price cap for multiple days during the event. Denton's net storm costs are net of receipts from ERCOT for generation delivered in the hours its gas and wind generation resources were available. Denton has taken steps to provide more resiliency should a similar event occur in the future, including winterization of its natural gas plant,the Denton Energy Center(DEC),increased customer communications regarding storm events,internal operational improvements and coordination,and revised load shed plan. Core Scientific Core Scientific is one of the largest publicly traded blockchain data center providers and miners of digital assets in North America.The company announced plans to expand its Denton,Texas data center in 2021 but filed for chapter 11 bankruptcy protection at the end of 2022,delaying the immediate completion of its data center expansion. Denton has adjusted and deferred its expectation for Core Scientific to reach its full 300 MW electric load capacity.The utility's protections against financial risk included in its seven-year PPA with the company place Core Scientific and the project developer with responsibility for all interconnection costs.Denton is responsible for protective interconnection equipment construction costs and will purchase all energy and related services from the ERCOT market with a pass-through of all actual costs. Daily settlement terms with Core Scientific will be consistent with those of ERCOT settlements,and include full securitization of potential payables with a short cure period for payment default. ERCOT requires that large data center loads,such as this one,register as Controllable Load Resources,which allows ERCOT to curtail the load under emergency grid conditions,such as occurred during the winter storm. https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 6/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable Sources of Information In addition to the sources of information identified in Fitch's applicable criteria specified below,this action was informed by information from Lumesis. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG CONSIDERATIONS Fitch has revised Denton's ESG Relevance Score to '3' from '4' for Exposure to Environmental Impacts (the prior score was based on the effects of the 2021 winter storm). Fitch expects statewide power market reforms enacted since the storm to reduce the utility's potential financial exposure during extreme weather events Unless otherwise disclosed in this section,the highest level of ESG credit relevance is a score of'3'.This means 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 Fitch's ESG Relevance Scores,visit www.fitchratings.com/esg FITCH RATINGS ANALYSTS Rebecca Meyer,CFA, CPA,CISA Director Primary Rating Analyst +1 512 215 3733 rebecca.meyer@fitchratings.com Fitch Ratings, Inc. 2600 Via Fortuna,Suite 330 Austin,TX 78746 Kathy Masterson Senior Director Secondary Rating Analyst +1 512 215 3730 kathryn.masterson@fitchratings.com Andrew DeStefano Director https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 7/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's Utility System Rev Bonds at'A';Outlook Stable Committee Chairperson +1 212 908 0284 andrew.destefano@fitchratings.com MEDIA CONTACTS Sandro Scenga New York +1 212 908 0278 sandro.scenga@thefitchgroup.com Additional information is available on www.fitchratings.com PARTICIPATION STATUS The rated entity(and/or its agents) or,in the case of structured finance,one or more of the transaction parties participated in the rating process except that the following issuer(s),if any,did not participate in the rating process,or provide additional information,beyond the issuer's available public disclosure. 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Fitch's approach to endorsement in the EU and the UK can be found on Fitch's Regulatory Affairs https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 11/12 8/9/23,4:23 PM Fitch Affirms Denton,TX's UtiIity%stem Rev Bonds at'A';Outlook Stable page on Fitch's website.The endorsement status of international credit ratings is provided within the entity summary page for each rated entity and in the transaction detail pages for structured finance transactions on the Fitch website.These disclosures are updated on a daily basis. https://vmw.fitchratings.conVresearch/us-public-finance/fitch-affirms-denton-tx utility-system-rev-bonds-at-a-outlook stable-09-08-2023 12/12 Fitch Ratings-Issuer Default Ratings AAA Highest credit quality AAA ratings denote the lowest expectation of default risk.They are assigned only in cases of exceptionally strong capacity for payment of financial commitments.This capacity is highly unlikely to be adversely affected by foreseeable events. AA Very high credit quality AA ratings denote expectations of very low default risk.They indicate very strong capacity for payment of financial commitments.This capacity is not significantly vulnerable to foreseeable events. A High credit quality A ratings denote expectations of low default risk.The capacity for payment of financial commitments is considered strong.This capacity may,nevertheless,be more vulnerable to adverse business or economic conditions than is the case for higher ratings. BBB Good credit quality BBB ratings indicate that expectations of default risk are currently low.The capacity for payment of financial commitments is considered adequate,but adverse business or economic conditions are more likely to impair this capacity. BB Speculative BB ratings indicate an elevated vulnerability to default risk,particularly in the event of adverse changes in business or economic conditions over time;however,business or financial flexibility exists that supports the servicing of financial commitments. B Highly speculative B ratings indicate that material default risk is present,but a limited margin of safety remains.Financial commitments are currently being met;however,capacity for continued payment is vulnerable to deterioration in the business and economic environment. CCC Substantial default risk CCC ratings indicate that default is a possibility. CC Very high default risk CC ratings indicate that a default of some kind appears probable. C Exceptionally high C ratings indicate that a default or default-like process has begun,or the issuer is in standstill,or for a closed default risk funding vehicle,payment capacity is irrevocably impaired. 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