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De Debt Mana bt Manageme gement nt Regula gulator tory y Acco Account unt - BCUC BCUC Wor

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January 27, 2016

B-2

BC HYDRO DEBT MANAGEMENT REGULATORY ACCOUNT

EXHIBIT

Welcome and Agenda

• Introduction to the Application
• Regulatory approvals sought
• Debt management strategy for future debt
• Mechanics and description of Future Debt Hedges
• Accounting options considered and risks / benefits
• Proposed accounting for Future Debt Hedges
• Description of Debt Management Regulatory Account
• Procedural discussion

2

Application

• BC Hydro proposes to enter into Future Debt Hedges (FDHs)

to mitigate the risk of rising interest rates

• Use of the Debt Management Regulatory Account (DMRA)

will allow BC Hydro to:

• ‘Lock in’ current low interest rates and reduce the likelihood of

intergenerational inequity and rate volatility

• Reduce risk of increased overall debt and finance charges as a

result of impacts on dividends

3

Approvals Requested

• Approval of a new DMRA effective on the date of the

Commission Order

• Commission endorsement of BC Hydro’s debt management

strategy for future debt

• Approval to record the amortization of Mark-to-Market gains
• r losses from the DMRA as finance charges

4

BC Hydro’s Forecasted Borrowing Requirements

• With the Ten Year Capital Forecast (to be provided in the RRA) and the Ten

Year Rates Plan (released November, 2013), BC Hydro has good insight into its borrowing requirements out to F2024

• BC Hydro is planning to invest an average of $2.4 billion / year in capital

expenditures to F2024

• BC Hydro’s overall debt is expected to increase by approximately $7 billion

to over $24 billion by F2024

• Taking into consideration long-term debt maturities over this period,

borrowing requirements are forecast to be approximately $10 billion

5

Debt Management Strategy Current vs Future

• Currently, the debt hedging activity that BC Hydro engages

in is limited to existing debt; mitigating BC Hydro’s current exposures

• BC Hydro has not made a practice of hedging the interest

rate on the issuance of future debt

• In the future, under BC Hydro’s debt management strategy,

we are looking to hedge future debt

6

Interest Rates

• Long term interest rates are at historic lows:

7 2 4 6 8 10 12 14 16

US Long Term Treasury Yields*

*Source: SidneyHomer, A history of Interest Rates

At a time when BC Hydro was making significant capital expenditures, there was a significant increase in long- term interest rates

Interest Rates and Hedging

• There is a limit to how low long-term interest rates can go
• The risk of higher interest rates is greater than the reward of lower

interest rates

• Recent economic developments have presented attractive interest rate

levels to secure long-term financing for long-term capital investments

• Given the relatively low level of interest rates and BC Hydro’s borrowing

requirements, we believe it is prudent to hedge the issuance of future debt so as to reduce ratepayers’ risk to higher interest costs

• This is not a speculative call on interest rates but an effort to reduce risk

and protect ratepayers

8

The Proposed Debt Management Strategy

• BC Hydro is proposing to hedge approximately 50%, or up to $5 billion, of its borrowing

requirements between F2017 and F2024

• A hedge ratio of 50% (vs 100%) allows BC Hydro to manage variability of cash flows and

participate in the benefits of interest rates not rising

• We are proposing two instruments for FDHs:
• Bond Locks: contracts with financial institutions that are based on the performance of

Government of Canada Treasury Bonds. Under a Bond Lock, BC Hydro will effectively sell a particular Government of Canada Bond at the current interest rate and effectively repurchase it at a pre-defined future date at the then-prevailing market interest rate; and

• Forward Interest Rate Swaps: contracts with financial institutions whereby BC Hydro will

pay the current interest rate on the Interest Rate Swap and agree to receive the prevailing interest rate on the Interest Rate Swap at a pre-defined future date

9

The Proposed Debt Management Strategy - Con’t

• Depending on market conditions at the time of execution,

we anticipate entering into approximately 20-30 FDHs between $100-400 million in notional value, which value coincides with typical debt issuance

• The FDHs will:
• have discrete maturities out to F2024,
• hedge a mix of 10 and 30 year yields, and
• be executed through the Provincial Treasury

10

Example of a Forward Interest Rate Swap Hedge

• BC Hydro is forecasting to issue $300 million of 10 year debt in F2020 (i.e.

three years from now) and wishes to hedge the rate today

• BC Hydro enters into an FDH with a notional value of $300 million whereby

BC Hydro agrees to pay the 13 year Interest Rate Swap (‘contract rate’) and to receive the prevailing rate on the 10 year Interest Rate Swap three years from now

• In three years’ time, if the FDH rate is higher than the 10 year Interest Rate

Swap (‘market rate’), the hedge will result in a loss, conversely if the contract rate is lower than the market rate the hedge will result in a gain

• The gain or loss on the FDH is exchanged via a cash payment in F2020

based on the calculation:

• Net Present Value [$300 million X (market rate – contract rate) X10]

11

Example: Interest Rates Increase

12

Example: Interest Rates Decrease

13

Interest Rates and Hedging

14

F2017 F2018 F2019 F2020 F2021 F2022 F2023 F2024

Prov BC 10 year bond forecast1

3.05% 3.67% 4.55% 5.55% 5.55% 5.55% 5.55% 5.55%

Future effective interest rate based on hedging2

2.35% 2.59% 2.60% 3.05% 3.20% 3.25% 3.30% 3.35%

1 provided by Ministry of Finance, October 2015 out to F2020, straight lined thereafter

2 the spread between the 10 year Interest Rate Swap and the Province of BC 10 year

bond is currently 60bp; this analysis assumes this spread is sustained

Interest Rates and Hedging - Con’t

• A 100 basis point change in interest rates on $5 billion of

FDHs intended to hedge the issuance of 10 year debt could create a mark-to-market gain or loss of approximately NPV $500 million

15

Risks to Hedging

• The risk that interest rates stay the same or go lower.
• In such an environment there will be a loss on the FDH, but BC

Hydro’s borrowing costs on 100% of its future debt will be lower than forecast

• The strategy hedges the underlying change in market interest

rates, the relative spread between the FDH and the Province of BC bond is unhedged

• Credit risk to the FDH counterparty
• Accounting risk

16

Accounting Options for Future Debt Hedges

• Mark-to-Market Accounting (default accounting treatment)
• Hedge Accounting (optional accounting treatment)

Accounting Objectives of Future Debt Hedges

• Ensure the gains / losses on the FDHs are recognized in the same

period as the interest cost of the future debt issuances

• Decrease likelihood of intergenerational inequity and rate volatility

17

Assumptions for the Graphs That Follow:

• F2016 – FDHs entered to lock in 3% interest rate on 10 year fixed debt of

$1 billion 2 years from now (total interest costs of $30 million per year)

• F2017 - 10 year fixed rate debt rate increases to 4% and remains at 4%
• F2018 - $1 billion 10 year fixed debt is issued at 4%
• A 1% increase in interest rates on $1 billion of 10 year debt hedges would

result in a gain of NPV of $100 million on the FDH

18

EXA EXAMPLE MPLE OF OF DES DESIRED IRED ACCOU CCOUNTING NTING TR TREA EATME TMENT NT OF OF FD FDHS

• Interest rate on $1 billion debt is locked in at 3%
• Gains on FDHs recognized in same period as interest cost of future debt

issues

• Interest costs are eligible for capitalization to assets under construction

5 10 15 20 25 30 35 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 In $ Millions Fiscal Year

Interest Costs

19

Option 1: Mark-to-Market Accounting In the Absence of Regulatory Accounting

• FDHs recognized at fair value immediately as finance charges
• Mark-to-market gains and losses on the FDHs recognized in current

period, prior to debt being issued

Impact of Regulatory Accounting

• Mark-to-market gains and losses are not forecast in BC Hydro’s

RRA, resulting in a finance charges variance

• Finance charges variances are deferred to the existing Total Finance

Charges Regulatory Account (TFCRA)

20

Benefits of Mark-to-Market Accounting

• Minimal administrative burden
• Accounting is straightforward
• Easy to understand

21

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS USIN USING G MAR MARK-TO TO- MARK MARKET ET ACCO CCOUNTING UNTING

• Ten year fixed rate debt increases to 4% in F2017, resulting in a $100

million gain on the market value of the FDHs. Total gain is charged to finance charges. Finance charges are subject to regulatory accounting

20 40 60 80 100 120 Fiscal 2017 In $ Millions

Total Finance Charges Regulatory Account

22

10 20 30 40 2020 2021 2022 In $ Millions Fiscal Year

P&L – Regulatory Account Amortization of FDH Gain

• $100 million in TFCRA amortized, assuming a 3 year test period in

fiscal 2020 RRA

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS USIN USING G MAR MARK-TO TO- MAR MARKET KET ACC CCOU OUNTIN NTING G - CON’T

23

10 20 30 40 50 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 In $ Millions Fiscal Year

Net Impact

• interest expense @ 4% x $1 billion debt. Eligible for capitalization to assets

under construction

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS USIN USING G MAR MARK-TO TO- MAR MARKET KET ACC CCOU OUNTIN NTING G - CON’T

24

• desired accounting treatment of FDHs

Risks of Mark-to-Market Accounting for FDHs

• Intergenerational inequity and rate volatility arising from a timing

mismatch of FDHs gains/losses and interest costs:

• Transfers to the TFCRA recovered in rates over the next revenue

requirements test period (1-3 years)

• Amortization of TFCRA not eligible to be capitalized as Interest

During Construction (IDC)

25

Option 2: Hedge Accounting

• Mark-to-market gains and losses on FDHs do not flow through

Net Income

• Gains and losses are recognized as Equity instead of finance

charges

26

• Reduces intergenerational inequity and rate volatility that
• ccurs under Mark-to-Market Accounting as long as the

hedge remains ‘effective’:

• Mark-to-market gains or losses recognized in Equity are

amortized to finance charges in future years to match against the cost and term of the future debt issues

• Amortization eligible to be capitalized as IDC

27

Benefits of Hedge Accounting

20 40 60 80 100 120 Fiscal 2017 In $ Millions

Gain on FDHs Deferred in Equity

• Ten year fixed rate debt increases to 4% in F2017, resulting in $100

million gain on the market value of the FDHs. Gain recognized in Equity

ACC CCOU OUNTIN NTING G FOR F FOR FDH DHS WITH WITH EF EFFE FECTIV CTIVE E HEDG HEDGE A E ACC CCOU OUNTIN NTING

28

• Capitalized interest expense @ 3% x $1 billion debt.

Eligible for capitalization to assets under construction

• desired accounting treatment of FDHs

5 10 15 20 25 30 35 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 In $ Millions Fiscal Year

Net Impact

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS WITH WITH EF EFFE FECTIV CTIVE E HEDGE HEDGE ACCO CCOUNTING UNTING – CON’T

29

• Intergenerational inequity and rate volatility if ‘hedge effectiveness’ is not

maintained on a quarterly basis

• To qualify for Hedge Accounting:
• 1. FDHs must be ‘highly effective’ in offsetting the changes in cash flow

due to interest rate changes at inception and throughout the term of the relationship

• The benchmark for ‘highly effective’ is a correlation of between

80%-125%

• 2. It must be ‘highly probable’ that the forecast issuance of debt will occur
• n the date as documented in the hedge documentation

Risks With Hedge Accounting

30

Risks With Hedge Accounting - Con’t

• Consequences of not maintaining ‘hedge effectiveness’:
• The hedge relationship is discontinued and Hedge

Accounting ceases

• Any subsequent changes in the fair value of the FDHs are

accounted for on a mark-to-market basis to finance charges (i.e. Mark-to-Market Accounting)

31

Risks With Hedge Accounting - Con’t

• The amounts previously recognized in Equity can continue to

remain in Equity, and be used to offset the interest costs on the future debt issuance, if it is still expected that the forecast debt issuance will occur

• If the future debt issue is no longer expected to occur, the

related cumulative gain or loss on the FDH previously recognized in Equity is immediately classified to finance charges

32

Risks With Hedge Accounting - Con’t

• Expensive (a minimum of $500k over life of FDHs)
• Documentation and effectiveness testing is complex and

difficult to administer

• Impact to BC Hydro’s dividend calculation and resulting

impact on future debt requirements

33

Impact on Dividends

• Under Hedge Accounting mark-to-market gains and losses of FDHs will be

recognized in Equity

• BC Hydro’s dividend is 85% of Net Income (until the end of F2017) subject

to BC Hydro maintaining a debt equity ratio of 80/20 - BC Hydro is currently not paying its full dividend due to its debt equity ratio

• Gains / losses recognized in Equity increase / decrease BC Hydro’s

dividend

• A $500 million gain in Equity in F2017 would increase the cumulative

dividend by $1.1 billion. This would increase debt and associated finance charges

• A $500 million loss in Equity in F2017 would decrease the cumulative

dividend by $900 million. This would decrease debt and associated finance charges

34

DEBT MANAGEMENT REGULATORY ACCOUNT (DMRA) AS AN ALTERNATIVE TO HEDGE ACCOUNTING

• DMRA is BC Hydro’s proposed alternative to Mark-to-Market

Accounting and Hedge Accounting

• Mark-to-market gains and losses on FDHs would be

recognized in the DMRA instead of Equity

• DMRA balance amortized to finance charges in future years to

match against the cost and term of the future debt issues

35

Benefits of the Proposed DMRA

• Ensures gains and losses on FDHs recognized in the same

period as the interest costs on the future debt

• Avoids intergenerational inequities and rate volatility
• Amortization of the DMRA balance to finance charges is

eligible to be capitalized to IDC

• Transparency
• Avoids all potential undesirable results of Mark-to-Market

Accounting and Hedge Accounting

36

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS USIN USING G DM DMRA RA

• Ten year fixed rate debt increases to 4% in F2017, resulting in a $100 million

gain on the market value of the FDHs. Gain is charged to DMRA.

20 40 60 80 100 120 Fiscal 2017 In $ Millions

DMRA

37

• Capitalized interest expense @ 3% x $1 billion debt. Eligible for

capitalization to assets under construction

• desired accounting treatment of FDHs

5 10 15 20 25 30 35 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 In $ Millions Fiscal Year

Net Impacts

ACC CCOU OUNTIN NTING G FOR FOR FDH FDHS USIN USING G DM DMRA RA – CON’T

38

1 2 3 4 5 6 7 2028 2077 In $ Millions Fiscal Years 2028 to 2077

• $300 million of interest costs capitalized as IDC is recognized in

Net Income as depreciation expense @ $6 million per year

• Asset has useful life of 50 years

DEPRECIA DEPRECIATION TION O OF F $3 $300 00 MILLION MILLION OF OF IN INTE TEREST REST CO COST STS S CA CAPIT PITALIZE ALIZED D AS AS IDC IDC

Conclusion

• The DMRA will capture the mark-to-market gains or losses on

Future Debt Hedges and amortize those amounts over the term of the associated future long-term debt as finance charges

• Removes the risk of an ineffective hedge
• No administrative burden
• Finance charges are also eligible to be included as IDC, to the

extent the debt relates to capital projects

• As IDC, finance charges would be amortized over the life of the

capital project

40

Conclusion – Con’t

• Amortization of gains or losses would commence in the test

period following the period in which the debt associated with a particular FDH is issued

41

Commission Reporting

1. BC Hydro proposes to track each specific Future Debt Hedge to the specific related debt contract 2. Semi-annual report to be developed in consultation with Commission staff

42