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2021-063 Utility S&P Fitch RatingsDate: August 20, 2021 Report No. 2021-063       INFORMAL STAFF REPORT TO MAYOR AND CITY COUNCIL SUBJECT: S&P Global and Fitch Ratings for the upcoming Utility System revenue refunding bond sale. BACKGROUND: The purpose of this report is to provide City Council notice of recent bond credit ratings from Fitch Ratings (Fitch) and Standard & Poor’s (S&P) for the upcoming Utility System revenue refunding bond sale. During July and August, staff and the City’s financial advisor, Hilltop Securities Inc., participated in conference calls with analysts from Fitch and S&P to discuss the City’s financials and upcoming Utility System bond sale. As a result of these conference calls, and a review of the Utility System’s financial information, S&P assigned a rating of ‘A+’ and Fitch assigned a rating of ‘A’. For your review, staff has attached the rating reports and a ratings definition chart for each rating agency. DISCUSSION: S&P affirmed its 'A-1' short-term rating on the Utility System commercial paper notes and 'A+' long- term rating on the Utility System outstanding debt. At the same time, S&P assigned its 'A+' long-term rating to the City's upcoming $141.3 million 2021 Utility System revenue refunding bond sale. Fitch has assigned an 'A' rating to the 2021 Utility System revenue refunding bonds which reflects a downgrade from the prior ‘A+’ rating assigned to the 2017 Utility System revenue bonds. The lower rating is the result of Fitch's expectation that the combined utility's leverage profile will weaken over the near term as a result of extraordinary winter storm costs and an expanded plan for capital improvements. In addition, to ensure parity between the upcoming and outstanding issuances, Fitch downgraded the rating on the 2017 Utility System revenue bonds from ‘A+’ to ‘A’. Interest the City pays on the existing Utility System bonds will not be impacted by the rating change. However, the lowered Fitch rating may slightly increase the interest costs on the new 2021 Utility System bonds. Future debt issuances for the Utility System in Certificate of Obligations (COs) will be backed by the City’s credit rating. The new ratings continue to classify the Utility System debt as “Investment Grade” and denotes the Utility System’s capacity for payment of financial commitments as strong. However, as noted in S&P and Fitch’s report, their assigned ‘Negative Outlook’ reflects susceptibility to the potential unknown industry-wide effects of regulatory reforms in the wake of the winter storm. For your review, staff has attached the Credit Opinion report from S&P and Fitch. ATTACHMENTS: S&P Credit Opinion Report Date: August 20, 2021 Report No. 2021-063       Fitch Credit Opinion Report Rating Definition Charts STAFF CONTACT: Cassey Ogden, Director of Finance (940)-349-7195 Cassandra.Ogden@cityofdenton.com Summary: Denton, Texas; CP; Combined Utility; Retail Electric Primary Credit Analyst: Paul J Dyson, San Francisco + 1 (415) 371 5079; paul.dyson@spglobal.com Secondary Contact: Doug Snider, Centennial + 1 (303) 721 4709; doug.snider@spglobal.com Table Of Contents Rating Action Negative Outlook Credit Opinion Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 1 Summary: Denton, Texas; CP; Combined Utility; Retail Electric Credit Profile US$141.285 mil util sys rev rfdg bnds ser 2021 dtd 08/15/2021 due 12/01/2051 Long Term Rating A+/Negative New Denton comb util Long Term Rating A+/Negative Affirmed, Removed from CreditWatch Denton util sys rev extendable cml pap nts prog ser A due 01/12/2031 Short Term Rating A-1 Affirmed, Removed from CreditWatch Rating Action S&P Global Ratings affirmed its 'A-1' short-term rating and 'A+' long-term rating on the City of Denton, Texas' utility system debt outstanding and removed the ratings from CreditWatch, where they had been placed with negative implications on March 3, 2021. At the same time, S&P Global Ratings assigned its 'A+' long-term rating to the city's $141.3 million series 2021 taxable utility system revenue refunding bonds. The outlook is negative. The CreditWatch removal reflects our view of the utility's refined policies and procedures and remediation plans with regard to the procurement, hedging, and management of natural gas for its 225-megawatt (MW) Denton Energy Center (DEC), including possible alternate fuel, second gas pipeline, and gas compressor station, and our view that Denton's exposure to the Electricity Reliability Council of Texas's (ERCOT) market price volatility this summer will likely be manageable because of the utility's dispatchable generation resources, overall expected long resource position, and exceptional system liquidity. The negative outlook reflects our view of Denton's increasing reliance on intermittent resources to meet peak load, with 58% of total resources consisting of nonfirm wind and solar energy, and uncertainty as to timing of completion and ultimate success of various gas supply initiatives or winterization projects for the DEC that Denton is considering or undertaking. We will monitor Denton's resiliency projects for the DEC and ERCOT market reforms to assess the utility's vulnerabilities given such a dependence on renewable resources, which, despite its environmental aims, could have negative credit implications. The negative outlook also reflects our view of the continued uncertainty associated with many factors facing utilities throughout the state, including an uncertain regulatory environment. We believe Denton, as with many other Texas utilities, could continue to face challenges associated with the market's relative price volatility, heightened gas and power reliability risks, extreme temperature and demand fluctuations, and weaker grid interconnectivity as compared with grids in other states. We could lower our long-term rating if our view of the utility's operations deteriorates or WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 2 Denton is unable to manage the risks associated with its participation in the ERCOT market. The bonds are being issued to refund $140 million in commercial paper (CP) outstanding that was issued to fund costs associated with the February winter storm (unofficially known as Uri). A first lien on net revenue of Denton's combined electric, water, and wastewater systems secures the proposed bonds and parity debt outstanding, with approximately $207 million in long-term debt outstanding as of fiscal year-end 2020. In addition, more than $450 million of general obligation bonds and other tax-secured debt was issued on behalf of the utility and is self-supported by limited surplus net revenue that is subordinate to the ECP; by practice, the combined utility fully self-supports the entirety of its allocable tax-backed debt. In fiscal 2020, the electric system alone accounted for the vast majority of net revenue available for debt service, making it the focus of our analysis. The short-term or CP rating is linked to the long-term rating based on the application of our "Methodology For Linking Long-Term And Short-Term Ratings," published April 7, 2017, on RatingsDirect. Credit overview During the week of Feb. 14, purchased power and natural gas prices skyrocketed, as extreme winter weather plagued the entire State of Texas. The cost to Denton is now estimated at approximately $141 million, largely because the DEC lost access to natural gas, leading to pipeline freeze-ups and an inability to operate for two days, and thus the electric system lost its natural hedge to high power prices that reached $9,000 per MW-hour for several days. In addition, demand was 30% above forecast peak load, which exacerbated the situation. Denton funded the costs through the issuance of CP. A couple weeks after the storm, the city disputed additional payments potentially due to ERCOT, and filed for and was granted a temporary restraining order seeking full relief from ERCOT's "uplift" mechanism, where if one or more ERCOT market participants fails to pay ERCOT for power purchases, those costs are spread to other ERCOT participants pro rata so that ERCOT can reimburse electricity suppliers. A local court has since dismissed Denton's case claiming that the Public Utility Commission of Texas has jurisdiction over the claim. As of June 22, Denton's electric system, Denton Municipal Electric, has been assessed $9.4 million in potential uplift or short pays attributed to defaulting market participants; management believes its short pay could be reduced or eliminated if certain market participants are able to take advantage of securitization legislation passed in June 2021. Including short pays, the total cost of the storm is approximately $150 million. Environmental, social, and governance (ESG) factors February's severe winter event has brought into sharper focus a spectrum of ESG-related risks that may inform our credit analyses and ratings over the longer term. In our view, the specter of climate change may weigh more heavily as a credit risk factor for Texas utilities. In particular, we expect to consider the adequacy of management's counterbalancing measures to plan for, mitigate, or adapt to risks associated with extreme weather conditions that have the potential to disrupt power generation and transmission, as well as gas supply. Among these considerations are exposures under hedging arrangements, plans relating to power plant weatherization and gas line redundancy, and capital and liquidity sufficiency. The combined utility has taken steps in recent years to reduce its carbon footprint and meet potential greenhouse gas WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 3 Summary: Denton, Texas; CP; Combined Utility; Retail Electric emission regulations, given that its power supply centers on renewables and natural-gas-fired peaking generation and has shifted away from coal. In February 2018, the city council adopted the Denton Renewable Resource Plan, which set a goal to have under contract 100% of the city's annual electricity from renewables by 2020. Assuming its intermittent assets perform, management reports that close to 100% of energy consumed each year will be renewable energy. We believe Denton's exposure to social factors could present elevated risk given below-average income indicators and above-average weighted average revenue per kilowatt-hour as a percentage of the state average for which Denton has used or will use reserves to manage affordability. In addition, almost half of its potential service territory, currently undeveloped, can be served by two other transmission/distribution utilities, with one offering retail choice. The city has not opted into customer choice so existing customers cannot switch. Overall, we have not seen competition manifest as a material credit risk to Denton. In our view, governance risk is heightened given that the environment in which Denton operates increasingly requires stronger liquidity, proactive planning, hedging, and financial flexibility, which come at a cost, versus utilities in other regions where these risks are lower. Negative Outlook Downside scenario We could lower the rating is Denton is unable to address its gas supply vulnerabilities and power plant reliability, or if the utility's dependence on renewable resources leads to materially worse financial metrics in stressed conditions. We could also lower the rating if actual peak summer or winter demand materially exceed projections and result in much higher costs and lower unrestricted cash and fixed-charge coverage (FCC). Return to stable scenario We could revise the outlook to stable if Denton's winterization and gas resiliency projects are successfully completed and, in our view, put the utility in a more stable position as relates to exposure to gas supply disruptions, extreme temperatures, and potentially volatile or high ERCOT market prices. We could also revise the outlook to stable if Denton is able to generate FCC materially above forecast and we come to believe such performance is sustainable. Credit Opinion The rating reflects our view of Denton's strong enterprise risk profile, with a diverse and primarily residential customer base, below-average income indicators, above-average electric rates, and mostly renewable power portfolio, although Denton's moderate reliance on intermittent power to meet peak load and challenges related to gas supply resiliency partly offset this. Our assessment of Denton's strong financial risk profile reflects our forward-looking view of lower FCC as result of increasing debt service requirements, very strong liquidity position (nearly 11 months' unrestricted cash), and manageable debt burden. We have applied a one-notch positive adjustment from the initial indicative rating to arrive at the final rating based on peer comparisons, including the utility's exceptional liquidity we consider to be supportive of the 'A+' rating, despite moderate operating risks. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 4 Summary: Denton, Texas; CP; Combined Utility; Retail Electric Denton's combined utility provides electric, water, wastewater, drainage, and solid waste services to the city. Median household effective buying income is 93% of the national average and weighted average electric system rates are 17% above the state average. These factors limit Denton's financial flexibility, although we understand that no rate increases are planned pending a cost-of-service study, none have been made for five years for the electric system, and water rates were reduced slightly in 2020. Water and wastewater operations are stable with ample system capacity, in our view. Denton's power supply includes its 225 MW gas-fired DEC, 30 MW of firmed wind power, and 150 MW of additional wind power. In addition to this, Denton has three purchased power agreements for 205 MW of solar for a total resource position of 610 MW versus peak summer load forecast at 375 MW. An additional 75 MW of solar through a purchased power agreement comes on line in 2022. Given that firm resources only cover about two-thirds of Denton's projected peak summer demand, we believe the electric system could face high market prices during extreme weather events and/or in cases where intermittent resources do not perform as expected. As a result of the February winter storm, Denton has revisited its policies, procedures, risk management practices, natural gas infrastructure condition, and power supply, and is undertaking or considering various projects to become more resilient. For 24 hours during the winter storm, natural gas was not flowing to the plant, and, when it began flowing again, the plant took another 24 hours or so to get almost fully back on line. To manage this risk, management is considering changes to the DEC so it can burn other types of fuel such as hydrogen or liquified natural gas, and local gas storage. It is also looking to add pipeline redundancy and to increase pressure on the gas lines to be better able to deliver gas to the DEC during times of significant demand. A new procedure has also been set up to ensure that sufficient staff are on hand to quickly drain fluid from the pipelines in case of a loss of pressure to avoid freeze-ups. Management also reports that it will hedge gas prices and volumes further in advance, and, if prices are rising, that it will hedge a greater quantity earlier. By revised policy, 100% of its forecast winter (December, January, and February) gas needs will be secured by Nov. 15. Nonetheless, an interruptible fuel supply and lack of certainty of supply temper the benefits of hedging. Management also plans to manage power supply and hedge positions six to 10 days and up to one month ahead of predicted extreme temperatures, rather than one to five days in advance. Under its financial modeling scenarios, Denton has determined that there is only a 10% chance peak demand will exceed its forecast; this has not happened in the summer historically. Management is also considering additional power supply contracts for renewables that are backed by firm power (which helped generate revenue from ERCOT during the winter storm), although those arrangements are substantially more costly than nonfirmed renewables. According to management's financial forecast, higher debt service requirements associated with the proposed CP refunding and additional debt issuances to fund 99% of its $213 million capital improvement plan will likely put pressure on Denton's FCC. We calculate that FCC will range from 1.1x to 1.3x over the next five years, down from about 1.4x on average in fiscal years 2018-2020, although, in our view, the financial forecast is conservative. System liquidity is robust with about $174 million in cash, or 334 days' operating expenses, as of fiscal 2020, with current liquidity balances virtually unchanged from those figures. We view such liquidity as a significant credit positive given the various operating risks facing Denton in the ERCOT market and given exposure to extreme temperature fluctuations and volatile market prices for power in the event that generation does not perform as expected (and in the WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 5 Summary: Denton, Texas; CP; Combined Utility; Retail Electric event of another gas supply interruption). In our view, Denton's debt to capitalization is manageable at about 48%. Related Research Through The ESG Lens 2.0: A Deeper Dive Into U.S. Public Finance Credit Factors, April 28, 2020 Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 6 Summary: Denton, Texas; CP; Combined Utility; Retail Electric WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 22, 2021 7 STANDARD & POOR’S, S&P and RATINGSDIRECT are registered trademarks of Standard & Poor’s Financial Services LLC. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. 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All rights reserved. 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 1/10 RATING ACTION COMMENTARY Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative Mon 16 Aug, 2021 - 5:48 PM ET Fitch Ratings - Austin - 16 Aug 2021: Fitch Ratings has assigned an 'A' rating to the following bonds issued by the city of Denton on behalf of its combined utility system: --$141.3 million utility system revenue refunding bonds, taxable series 2021. Bond proceeds from the series 2021 bonds will be used to refund extendable CP (ECP) amounts used to fund extraordinary storm costs associated with above budget energy and natural gas prices experienced during Winter Storm Uri in February 2021. Proceeds will also be used to fund costs of issuance. The bonds are expected to price on Aug. 26, 2021 via negotiated sale. In addition, Fitch downgrades the rating on the following parity bonds issued by the city to 'A' from 'A+': ---$199.3 million utility system revenue bonds, series 2017. Fitch assesses Denton's standalone credit prole (SCP) at 'a'. The SCP represents the credit prole of the utility on a stand-alone basis, irrespective of its relationship with the related credit quality of the city of Denton (AA+/Stable). The Rating Watch Negative (RWN) is removed from the series 2017 bonds. The Rating Outlook on all of the bonds is Negative. ANALYTICAL CONCLUSION The downgrade to 'A' from 'A+' reects Fitch's expectation that the combined utility's leverage prole will weaken over the near term as a result of debt nancing related to extraordinary winter storm costs, as well as an expanded plan for capex. Weaker operating income is also anticipated as Denton has delayed consideration of electric rate increases and has assumed a transmission rate reduction beginning in 2023. Lower funds available for debt service (FADS) and higher debt issuance in 2022-2026, are expected to push the utility's leverage ratio above 9x over the next ve years, a level more commensurate with an 'A' rating. Fitch's removal of the RWN designation is based on the adequacy of the city's liquidity sources during, and since, the winter storm event. Robust cash reserves and the city's extendible CP programs allowed the utility to meet cash payments due during and immediately following the storm. The Negative Outlook reects Fitch's view that ongoing state investigations, the implementation and rule-making process associated with state legislative efforts to address the exceptional market risks of the Electric Reliability Council of Texas (ERCOT) exposed by Winter Storm Uri, multiple legal cases, and the lack of resolution of the approximately $3.0 billion shortfall in payments to ERCOT continue to pose risk with unknown credit implications. The overall risk exposure for utilities such as Denton, required to transact all energy sales and purchases through ERCOT, remains pronounced. CREDIT 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 142,000, Denton is located at the northern end of the Dallas-Fort Worth (DFW) metro area. The local economy features institutions of higher education, a regionally prominent medical sector, and a strong warehousing and manufacturing 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 2/10 base. 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 (76% in FY20). Denton's electric system serves an approximately 55 square mile, single-certied area within city limits and an additional 53 square mile area that is multiply certied outside of the city's boundaries. The electric system served approximately 56,400 customers in scal 2020. Customer growth is strong, averaging 2.4% over the last ve years. Denton embarked on a trajectory to increase its renewable energy supplies and over 60% of energy supply was provided by wind and solar resources in scal 2020. 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. Winter Storm URI Denton's net storm costs are estimated at approximately $141 million, allocable to the electric utility. The cost estimate includes 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. While the net amount is estimated at $141 million, initial cash outows were higher at over $200 million, before Denton began to receive offsetting receipts for generation sold into the ERCOT market. Denton successfully managed the acute liquidity demands of the event by issuing $100 million in ECP during the week of the storm and increasing the authorization of the ECP program to $300 million in the days following the storm. The ECP proceeds, along with Denton's electric cash reserves (equal to 383 days cash on hand at the end of scal 2020) were used to satisfy immediate cash needs during the storm. Proceeds of the series 2021 bonds will renance ECP notes into long- term debt. Denton Litigation with ERCOT Dismissed The city of Denton led suit against ERCOT in February 2021 to prevent being allocated any of the ERCOT defaults from other parties, arguing that paying for the defaults of other entities would constitute an unconstitutional gifting of public funds. A temporary restraining order was initially granted, preventing ERCOT from allocating any of the uplift costs to the city of Denton in the early weeks following the storm. In June, the court dismissed the case and ERCOT invoiced Denton for approximately $9.4 million for its allocable share of the short payment amount. Denton did not appeal the court decision in light of state legislation passed in the interim designed to ultimately address the full amount of ERCOT shortfall payments through various securitization nancings. KEY RATING DRIVERS Revenue Defensibility: 'aa' Growing Retail Municipal Utility with Rate Flexibility Revenues are provided 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 averaging 2.4% annually, median household income (MHI) levels in line with the national average and low unemployment. The utility has competitive, highly affordable utility rates, supported by the city's independent rate authority. Operating Risk: 'a' Low Cost Burden; Weaker Operating Cost Flexibility 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 3/10 Denton's operating cost burden remains low, at 11.5 cents per kWh in scal 2020, including franchise fees and return on investment paid to the city of Denton general fund. Fitch considers operating exibility weak based on Denton's rm capacity concentration in gas and ERCOT's structural market weaknesses exposed by the February 2021 winter weather event. Capital spending continues to escalate with a 19% increase in the $595 million ve-year capital improvement plan (CIP; 2022-2026) over the 2021-2025 plan, following a 38% increase the year prior. Fitch expects 88% of the ve-year CIP to be debt nanced. Financial Prole: 'a' Leverage Increasing from Increased Capital and Storm Costs Fitch expects Denton's leverage prole to weaken as storm-related costs are nanced over 30 years and planned capital spending requires additional debt. Fitch expects leverage (measured by Fitch as net adjusted debt to adjusted funds available for debt service) to end FY2021 at around 9x (compared to 6.1x at the end of FY2020) and to trend upwards from 9x to 10x over the next ve years. Coverage of full obligations was 1.2x in FY2020, and Fitch expects it to remain in this range. No rate increases are planned for the three utilities. Cash reserves and the city's extendable CP program supported Denton's ability to handle the liquidity crisis associated with the winter storm and payments due to ERCOT within days of the event. The city intends to increase its minimum reserves target at the electric utility to 175 days of budgeted expenditures, up from 60 days. The new policy is subject to nal approval by City Council. ASYMMETRIC ADDITIONAL RISK CONSIDERATIONS No asymmetric additional risk considerations affected the rating outcome. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: --Stabilization of the Negative Outlook will depend on actions by the state and market regulators to reduce nancial risk to ERCOT market participants and resolution of the approximately $3 billion net short amount that remains unpaid to ERCOT; --Lower than expected capital spending, or increased pay-go funding of the capital program could lower leverage from current anticipated levels. Factors that could, individually or collectively, lead to negative rating action/downgrade: --Legislative or regulatory changes that impose material new capex or operating costs for utilities; --Lower operating margins and cash ow as a result of an increase in operating expenses, including transfer payments to the city of Denton's General Fund; --Weaker liquidity prole or leverage consistently above 10x in Fitch's base or 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 (dened 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 (dened 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-specic best- and worst-case scenario credit ratings, visit https://www.tchratings.com/site/re/10111579. SECURITY The bonds are payable from the net revenues of the combined utility system, including the water, wastewater, and electric light and power systems. 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 4/10 REVENUE DEFENSIBILITY Denton derives its revenues from the sale of electric (76%), water (17%) and wastewater (7%) services to retail customers. Denton's electric system serves an approximately 55 square mile, single certied area within the city of Denton's city limits and an additional 53 square mile area that is served by multiple suppliers outside of the city's boundaries. The electric system served approximately 56,400 customers in scal 2020. The city has not opted-in to retail competition. However, the system does face limited competition based on new customers that move into limited dual and triple certied areas around the perimeter of the city of Denton. Roughly 6% of Denton's electric customers reside in the multi-certicated area. SERVICE AREA CHARACTERISTICS Demand for services is supported by strong customer growth, averaging 2.4% over the past ve years. Average electric sales over the same period has been more measured, averaging 0.6%, and reecting national trends of energy efciency and declining per capital electric usage. Service area characteristics in the city of Denton include median household income (MHI) that approximates the national average and unemployment that has been well below the national average in recent years (85% in 2020). Unemployment metrics increased in 2020 given the economic challenges of the coronavirus pandemic, but the city's unemployment levels remained below the state and national levels. Higher unemployment levels have begun to trend down in 2021. The utility customer base is well diversied and exhibits no concentration. Residential electric revenue accounts for about 45% of revenue and 40% of sales. Top-10 electric customers provided about 19% of electric revenues in scal 2020, the largest of which, University of North Texas, accounted for approximately 4% of electric revenues, down slightly from typical levels due to the closure of the campus in spring 2020 due to the coronavirus. The water system's top-10 customers, including wholesale customers, reect relatively stable entities, including the University of North Texas, the local school district, and local health centers and hospitals. Top-10 customers of the water and wastewater systems comprise approximately 10% or less of the respective system revenue. RATE FLEXIBILITY Rate exibility is very strong. Utility rates are determined independently by City Council and are not subject to third-party regulation. Electric distribution rates approximate that of the state and are highly affordable. According to the most recent data available from the US Energy Information Administration in 2019, Denton's average retail electric rate is 110% of the state average but average residential revenue is more competitive at 91% of the state residential average. Total average annual energy costs as measured as a percentage of MHI was 2.2% in 2019, indicating very high affordability. Electric rates include xed and volumetric charges and adjustable components to recover or return costs that exceed or outperform budgeted levels. The energy cost adjustment factor (ECA) is adjusted on a quarterly basis to stay within a $5 million over/under range on fuel and purchased power costs. Rates also include a transmission cost recovery (TCR) factor, adjusted annually, that recovers the utility's net transmission costs from its electric customers. The city receives approximately 25% of its electric revenues from its owned transmission assets. Transmission revenues are collected from utilities across the ERCOT regional market, as opposed to Denton's retail electric customers, to socialize transmission costs across the state. Denton collects a regulated transmission tariff on its owned transmission assets. Transmission rates are regulated by the Public Utility Commission of Texas (PUCT). The PUCT has required Denton to complete a full transmission cost of service ling by November 2021 to consider the city's transmission tariff. OPERATING RISK Denton's operating cost burden over the past ve years (calculated by Fitch as total electric operating costs in relation to energy sales) has been low and relatively stable at around 11 cents per kWh over the last three years, with the exception of scal 2019 when expenditures included a large one-time noncash decommissioning expense for the Gibbons Creek coal plant. Renewable Resource Plan Denton embarked on a renewable energy plan in 2015, adopted as the Denton Renewable Resource Plan (DRRP) in 2018, with a goal to secure 100% of its energy demand through renewable purchase power agreements (PPA) by 2020. The DRRP incorporated the closure of 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 5/10 Gibbons Creek, a coal-red power plant owned by the Texas Municipal Power Agency (TMPA) and replaced the loss of this capacity with Denton's construction of the Denton Energy Center (DEC) that entered commercial operation in 2018 and multiple wind and solar PPAs. Denton has entered into a large wind PPA for the 150 MW Santa Rita wind project located in Texas, which began delivery wind energy to the city in 2018. While deliveries uctuate with wind conditions, the PPA still provided a signicant 43% of Denton's energy supply in scal 2020. Denton has another older, rm wind PPA for 30 MW from the Wolf Ridge wind project that provided another 17% of energy in scal 2020. The Santa Rita contract was unable to deliver during Winter Storm Uri but deliveries continued from the Wolf Ridge site, although wind was conditions were very low during the storm event. Denton Energy Center The other large component of Denton's energy portfolio is the DEC. The DEC is a 225 MW combined cycle natural gas-red generation plant located in the city of Denton. The DEC is designed to rm the intermittent renewable resources provided by PPAs and to act as a physical price hedge against potential high market prices within ERCOT. The DEC provided 24% of energy supply in scal 2020 and the balance was supplied from smaller solar and landll gas contracts and market energy purchases. Gas deliveries to the DEC were curtailed during Winter Storm Uri, which in turn, resulted in a freezing of certain plant components. The city is exploring options to improve gas supply reliability at the DEC, including the installation of a second delivery pipeline to the plant, installation of a natural gas compressor to support pressure on the existing delivery pipeline, or installation of on-site liquied natural gas storage. General Fund Transfers Fitch's operating cost calculation includes the electric fund transfer to the city's general fund. Each of the three utilities make transfer to the general fund equal to an indirect cost allocation, a 3.5% return on investment (ROI) and a payment in lieu of franchise fees equal to 5% of revenues. While the indirect cost allocation portion of the transfer is considered an operating expense, the other components are subordinate to debt service per the revenue bond ordinance. All three components are included in Fitch's calculation. Following the closure by TMPA of Gibbons Creek and related cost savings that occurred as a result of that closure, City Council increased the return on investment (ROI) from the electric fund to the general fund to 6% from 3.5% in April 2020 through the end of scal 2022. The increase was designed to mitigate the potential shortfall of economically sensitive sales tax and potential attening of property tax values associated with the developing coronavirus pandemic. The increase in the ROI accounts for a $2 million increase in the electric fund's scal 2020 transfer and $5 million annually through scal 2022. The temporary increase has not been reversed in light of the magnitude of storm costs facing the electric utility. OPERATING COST FLEXIBILITY Fitch views Denton's operating cost exibility as weak as a result of its natural gas concentration as well as its reliance on the ERCOT market, which exhibited thinning reserve margins even before the 2021 winter storm event. The majority of Denton's capacity, 225MW, is provided from natural gas-red DEC combined cycle plant and represents rm capacity, along with 30MW from Wolf Ridge. Denton also has intermittent capacity - 150 MW from the Santa Rita Wind Project and several solar projects. Denton uses nancial transactions to cover its peak demand, 356MW in scal 2020, in excess of its owned/contracted capacity. The energy risk management program is currently a three-year program. In addition, the weak operating exibility assessment reects the systematic failure of the ERCOT organized market to consistently supply energy, albeit during an unparalleled series of winter storms and cold weather, which resulted in widespread blackouts across the region. Denton was required by ERCOT to shed 25% of its load during the storm event. The weaknesses of the ERCOT organized market exposed by this event could limit Denton's ability to preserve or manage costs during adverse operating conditions in the future. CAPITAL PLANNING AND MANAGEMENT Fitch considers lifecycle investment needs as moderate, although Denton's increased its CIP reects larger planned investments in system aging infrastructure, specically the wastewater system. Denton's ve-year CIP (2022-2026) is projected at $595 million, up from the $501 million 2021-2025 CIP and the $363 million capital plan (2020-2024) considered two years ago. While the capital spending amounts for the electric and water utilities are slightly higher, the bulk of the increase occurred in projected spending for the wastewater utility. Management indicates the increases represent needed investment in aging infrastructure and capital 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 6/10 needs should decline after the current ve-year CIP. The CIP also does not include potential weatherization or dual fuel options under consideration for the electric utility. Water System The water system provides retail water service to a growing customer base within the city and sells raw and treated water wholesale to the Upper Trinity Regional Water District (UTRWD) for resale to two of its customer cities. Wholesale sales comprise less than 2% of total gallons sold. Raw water supplies and treatment capacity appear sufcient to meet expected water demands. The water system experienced operational impacts from Winter Storm URI but did not experience material over budget costs like the electric utility. The water system's top 10 customers, including wholesale customers reect relatively stable entities, including the University of North Texas, the local school district, and local health centers and hospitals. Top 10 customers comprise approximately 10% of water revenues. Wastewater System The wastewater system provides retail wastewater collection and treatment service to a growing customer base within the city and to four wholesale customers. Treatment capacity is sufcient. The top ten customers contribute less than 10% to the wastewater system's revenue. FINANCIAL PROFILE Denton's operating performance has exhibited variability, but remained generally strong. The combined utility system's leverage ratio has ranged between 6x and 10x over the ve-year period, reecting variability in operating income and FADS, as well as higher levels of outstanding debt beginning in scal 2017 and used to nance the DEC construction. Denton's leverage ratio declined to 6.1x in scal 2020 with stronger cash ow resulting from lower expenditures and relatively strong sales, notwithstanding the closures of a few of its largest electric customers during the initial months of the coronavirus pandemic. Leverage is expected to weaken in 2021 with the approximately $141 million in storm-related debt and issuance of $77 million to fund a portion of the combined utility CIP. Fitch anticipates leverage will end FY2021 at around 9.0x, assuming the regulatory deferral treatment of the extraordinary storm costs over 30 years to match the amortization of the related debt. Robust Liquidity Buffers Winter Storm Liquidity Crisis Liquidity is considered neutral to the rating, but Denton's strong reserve levels and available liquidity through the extendable CP program were instrumental in responding to the winter storm event and the acute liquidity crisis that developed within days. Combined utility cash on hand totaled 383 days at the end of scal 2020, which cash reserves at the electric fund accounted for approximately $83 million of the $173.6 million in unrestricted cash at the end of scal 2020. A portion of the reserves for each of the utilities are held in a designated rate stabilization fund. The winter storm event prompted Denton to increase its minimum targeted reserves levels, subject to nal approval by City Council in September. The proposal will increase the electric fund target for working capital and operating reserves of at least 175 days of budgeted expenses, up from 60 days. The new policy will result in electric fund reserves of at least $100 million. The water and wastewater funds each have respective minimum reserve targets of 120 days and 100 days, given the large capital programs underway at those utilities to meet new customer growth requirements. Fitch Analytical Stress Test (FAST) - Base Case and Stress Case Fitch's analysis and Fitch Analytical Stress Test (FAST) are informed by Denton's combined utility nancial projections. Denton's sales forecast reects generally robust growth for all three utilities over the next ve years and no base rate increases are assumed for any of the three utilities. The forecast also factors a reduction in transmission revenues given the ongoing transmission rate case. Fitch assumes the cost of power to grow at the same rate as energy. Base case capital requirements and debt issuances are informed by the utility's forecast, which have increased since last year. Fitch's base case scenario indicates that Denton's leverage ratio is expected to increase to between 9x and 10x over the next ve years, driven primarily by the increased debt funding to support higher capex, no planned rate increases at any of the three utilities and expectations for lower transmission revenues. To the extent that actual capex and debt issuance occurs below projected levels, as it has in recent years, leverage should remain closer to 9x. Coverage and liquidity levels remain consistent with historical levels. 8/16/2021 Fitch Rates Denton, TX's Utility System Rev Bonds 'A'; Outlook Negative https://www.fitchratings.com/research/us-public-finance/fitch-rates-denton-tx-utility-system-rev-bonds-a-outlook-negative-16-08-2021 7/10 Fitch's stress case imposes a modest decline in energy demand to the existing base case expectations in the rst two years, followed by a three-year recovery. Water, wastewater and transmission revenues are not stressed. The stress case indicates that leverage could be marginally higher in certain years, but should approximate 10x. DEBT PROFILE Denton's debt prole is neutral to the rating. The majority of the city's utility debt is in the form of general obligation (GO) bonds and certicates of obligation (CO) that are issued and secured by a dual pledge of utility system revenues and general government tax receipts but consistently paid from utility system revenues. The combined utility has approximately $530 million in GO and CO debt, including the series 2021 COs issued in May 2021. Fitch's coverage and debt calculations include the GO and CO bonds and the respective debt service paid by the utility systems. Utility system revenue bonds include the series 2017 and series 2021 bonds, outstanding following the current issuance, at approximately $340 million. Similar to the revenue mix, the electric system is responsible for the majority (over 80%) of the total combined debt obligations of the electric, water and wastewater debt. All of the outstanding long-term debt is xed rate with a nal maturity in 2050. The ECP program (not rated by Fitch) is the only variable rate debt in the portfolio. In addition to the sources of information identied in Fitch's applicable criteria specied 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 Denton (TX) [Electric] has an ESG Relevance Score of '4' for Exposure to Environmental Impacts due to the extreme winter weather event in February 2021 and structural aspects of the ERCOT organized market that resulted in extraordinary energy cost increases, which has a negative impact on the credit prole, and is relevant to the ratings in conjunction with other factors. 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. 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Utilities and Power US Public Finance North America United States S&P Long-Term Issue Credit Ratings S&P Short-Term Issue Credit Ratings 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 default risk C ratings indicate that a default or default-like process has begun, or the issuer is in standstill, or for a closed funding vehicle, payment capacity is irrevocably impaired. Note: The modifiers "+" or "-" may be appended to a rating to denote relative status within major rating categories.