Fitch Affirms Hydro-Quebec's C$44.2B Unsecured Debt at 'AA-'; Outlook Remains Negative

Fitch Ratings affirms the following ratings for Hydro-Quebec (HQ):

--Long-term Issuer Default rating at 'AA-';

--Short-term Issuer Default rating at 'F1+';

--$C44.2 billion parity unsecured debentures and medium-term notes at 'AA-';

--$US3.5 billion or equivalent in C$ commercial paper program at 'F1+'.

The Rating Outlook remains Negative.

SECURITY

HQ's debentures are unconditionally guaranteed by the Province of Quebec (rated 'AA-'; Outlook Negative by Fitch).

KEY RATING DRIVERS

PROVINCIAL RATING: HQ's Negative Outlook reflects the Negative Rating Outlook currently maintained by Fitch on the province. HQ's ratings are closely linked to the province, reflecting the government of Quebec's unconditional guarantee. The guarantee ranks equally in right of payment with Quebec's other unsecured obligations for borrowed money.

SOUND FINANCIAL POSITION: HQ has exhibited strong financial performance over the past five fiscal years, with average annual debt service coverage of 1.78x, after accounting for substantial transfers to the province as operating expenses. Net income for the first nine months of fiscal 2014 (C$2.58 billion) is 21% higher than the same period of the prior year, largely driven by colder weather conditions and exports.

LOW-COST HYDROELECTRIC POWER: Low-cost and largely carbon-free hydroelectric power resources (average production cost of 1.98 cents/kilowatt hour) result in some of the lowest retail rates in North America and spur considerable exports that benefit HQ's financial position. HQ's distribution and transmission divisions, which account for 31.3% of 2013 consolidated net income, are regulated on a cost-of-service basis.

LARGE CAPITAL PROGRAM: HQ's sound financial position and provincial guarantee mitigate concerns over its substantial capital program and accompanying use of leverage. HQ's equity-to-capitalization ratio has stabilized at about 30% compared with the rating category median of 53%. HQ spent C$4.3 billion on capex in 2013, including a record C$1.9 billion in transmission.

SIZEABLE COMMERCIAL PAPER PROGRAM: HQ's commercial paper (CP) program (authorized to $US3.5 billion or equivalent in C$) is supported by a bank credit facility sized at $US2 billion that expires in April 2019. While the credit facility does not fully cover the liquidity exposure up to the maximum size of the CP program, it is still rated 'F1+' due to the added support provided by the provincial guarantee (province short-term rating of 'F1+) and available cash reserves of HQ ($2.2 billion at Sept. 30th, 2014).

RATINGS SENSITIVITIES

RELATIONSHIP TO PROVINCIAL RATING: Fitch traditionally rates HQ in line with the Province of Quebec, given the provincial ownership of HQ, considerable annual fund transfers from HQ to the province (approximately 25% of HQ consolidated revenues in 2013), and the province's guarantee of HQ's debt. Consequently, the resolution of the Negative Outlook is expected to be consistent with the resolution of the province's Negative Outlook.

UTILITY FUNDAMENTALS SOUND: Although unlikely at the current rating level, HQ's rating could be revised separately from rating action on the province, if Fitch determined that HQ's utility operations, projected financial performance, and independence from the province supported a higher rating than that provided by the guarantee.

CREDIT SUMMARY

HQ is a vertically integrated electric system in Canada, providing electric service to virtually all of Quebec, or roughly 4.1 million customer accounts. Ownership of 36.1 GW of installed generating capacity and 33,885 kilometers of transmission lines place HQ among the largest electric systems in North America.

HQ is composed of four principal operating divisions:

--Hydro-Quebec Production (power generation);

--Hydro-Quebec TransEnergie (transmission service);

--Hydro-Quebec Distribution;

--Hydro-Quebec Equipement et Services partages and Societe d'energie de la Baie James (construction division).

Transmission and distribution services are provided under regulated tariffs.

HYDROPOWER DEVELOPMENTS

In 2013, HQ commissioned the last of its Eastmain-1A/Sarcelle/Rupert hydropower project (total of 918 MW), with construction completed on-time and within budget. Most recently in 2014, Romaine-2 (640MW), the first power plant of the 1,550 MW Romaine hydropower complex was also completed as scheduled.

With these recent power additions, the unregulated production division continues to expand its contribution to HQ consolidated revenues, accounting for more than half of the total in 2013. While the majority of the production division's revenues (76% in 2013) are contracted sales to Quebec's distribution division, its export sales are growing. Going forward, reliance on net income from the production division is projected to rise as the rest of the Romaine hydropower complex is completed and off-system sales expand - primarily from power exports into the U.S. Export sales, while growing, can be subject to greater price and volume variability than the contracted sales within Quebec.

Favorably, HQ's vast hydropower portfolio is a valued resource as it is both renewable and 'green' (extremely low carbon emitting). Additionally, HQ's hydropower is uniquely supported by substantial reservoirs, which helps mitigate exposure to variable hydrological conditions, unlike most other hydropower-based systems Fitch rates.

STABLE FINANCIAL PROFILE

Consolidated net income reached C$2.9 billion in 2013 compared with C$860 million in 2012, after a C$1.9 billion one-off impairment charge from the closure of the Gentilly-2 nuclear station. Dividends paid to the sole shareholder (the Province of Quebec) increased to C$2.2 billion, and debt service coverage was strong at 2.89x (2013). Coverage of full obligations, which incorporates transfers to the Province as an operating expense, remains sound at 1.92x for fiscal year end 2013.

For the first nine months of 2014, colder weather, higher distribution system rates and stronger net electricity exports contributed to a C$445 million increase in HQ's net margins to C$2.58 billion compared with the same period in the prior year. Unrestricted cash balances ($C2.2 billion) remain healthy at 207 days operating funds as of Sept. 30, 2014.

STAGGERED BUT LARGE DEBT MATURITIES

Despite HQ'S substantial debt capitalization, debt maturities are staggered with some of the largest coming due between 2035 and 2050. Near-term maturities include modest amounts (relative to HQ's 2013 revenues of C$12.9 billion, ranging from C$123 million to C$3.0 billion for the period 2015 - 2020. Fitch believes that HQ should be able to sustain cash flow interest coverage in the 1.75x range and equity capitalization of roughly 30%.

Additional information is available at 'www.fitchratings.com'.

This rating action was informed by information identified in Fitch's U.S. Public Power Rating Criteria.

Applicable Criteria and Related Research:

--'Fitch Affirms Province of Quebec at 'AA-'; Outlook Remains Negative' (Aug. 27, 2014);

--'U.S. Public Power Peer Study -- June 2014' (June 13, 2014);

--'U.S. Public Power Peer Study Addendum -- June 2014' (June 13, 2014);

--'U.S. Public Power Rating Criteria' (March 18, 2014).

Applicable Criteria and Related Research:

U.S. Public Power Peer Study -- June 2014

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749789

U.S. Public Power Peer Study Addendum - June 2014

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750283

U.S. Public Power Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=740841

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=956815

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