BC H YDRO D EBT M ANAGEMENT R EGULATORY A CCOUNT E XHIBIT B-2 Debt Mana De bt Manageme gement nt Regula gulator tory y Acco Account unt - BCUC BCUC Wor orkshop kshop January 27, 2016
Welcome and Agenda o Introduction to the Application o Regulatory approvals sought o Debt management strategy for future debt o Mechanics and description of Future Debt Hedges o Accounting options considered and risks / benefits o Proposed accounting for Future Debt Hedges o Description of Debt Management Regulatory Account o Procedural discussion 2
Application o BC Hydro proposes to enter into Future Debt Hedges (FDHs) to mitigate the risk of rising interest rates o Use of the Debt Management Regulatory Account (DMRA) will allow BC Hydro to: o ‘Lock in’ current low interest rates and reduce the likelihood of intergenerational inequity and rate volatility o Reduce risk of increased overall debt and finance charges as a result of impacts on dividends 3
Approvals Requested o Approval of a new DMRA effective on the date of the Commission Order o Commission endorsement of BC Hydro’s debt management strategy for future debt o Approval to record the amortization of Mark-to-Market gains or losses from the DMRA as finance charges 4
BC Hydro’s Forecasted Borrowing Requirements o 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 o 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 o to over $24 billion by F2024 o 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 o Currently, the debt hedging activity that BC Hydro engages in is limited to existing debt; m itigating BC Hydro’s current exposures o BC Hydro has not made a practice of hedging the interest rate on the issuance of future debt o In the future, under BC Hydro’s debt management strategy, we are looking to hedge future debt 6
Interest Rates o Long term interest rates are at historic lows: 16 US Long Term Treasury Yields* 14 12 At a time when BC Hydro was making significant capital 10 expenditures, there was a significant increase in long- term interest rates 8 6 4 2 0 *Source: SidneyHomer, A history of Interest Rates 7
Interest Rates and Hedging o There is a limit to how low long-term interest rates can go o The risk of higher interest rates is greater than the reward of lower interest rates o 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 o requirements, we believe it is prudent to hedge the issuance of future debt so as to reduce ratepayers’ risk to higher interest costs o This is not a speculative call on interest rates but an effort to reduce risk and protect ratepayers 8
The Proposed Debt Management Strategy o BC Hydro is proposing to hedge approximately 50%, or up to $5 billion, of its borrowing requirements between F2017 and F2024 o 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 o We are proposing two instruments for FDHs: o 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 o 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 o 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 o The FDHs will: o have discrete maturities out to F2024, o hedge a mix of 10 and 30 year yields, and o be executed through the Provincial Treasury 10
Example of a Forward Interest Rate Swap Hedge o 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 o 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 o 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 o The gain or loss on the FDH is exchanged via a cash payment in F2020 based on the calculation: o 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 F2017 F2018 F2019 F2020 F2021 F2022 F2023 F2024 Prov BC 10 year bond 3.05% 3.67% 4.55% 5.55% 5.55% 5.55% 5.55% 5.55% forecast 1 Future effective 2.35% 2.59% 2.60% 3.05% 3.20% 3.25% 3.30% 3.35% interest rate based on hedging 2 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 14
Interest Rates and Hedging - Con’t o 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 o The risk that interest rates stay the same or go lower. o 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 o The strategy hedges the underlying change in market interest rates, the relative spread between the FDH and the Province of BC bond is unhedged o Credit risk to the FDH counterparty o Accounting risk 16
Accounting Options for Future Debt Hedges o Mark-to-Market Accounting (default accounting treatment) o Hedge Accounting (optional accounting treatment) Accounting Objectives of Future Debt Hedges o Ensure the gains / losses on the FDHs are recognized in the same period as the interest cost of the future debt issuances o 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 o $1 billion 2 years from now (total interest costs of $30 million per year) o F2017 - 10 year fixed rate debt rate increases to 4% and remains at 4% o F2018 - $1 billion 10 year fixed debt is issued at 4% o 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 FDH S Interest Costs 35 30 In $ Millions 25 20 15 10 5 0 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Fiscal Year - 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 19
Option 1: Mark-to-Market Accounting In the Absence of Regulatory Accounting o FDHs recognized at fair value immediately as finance charges o 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 o RRA, resulting in a finance charges variance o Finance charges variances are deferred to the existing Total Finance Charges Regulatory Account (TFCRA) 20
Benefits of Mark-to-Market Accounting o Minimal administrative burden o Accounting is straightforward o Easy to understand 21
ACC CCOU OUNTIN NTING G FOR FOR FDH FDH S USIN USING G MAR MARK-TO TO- MARK MARKET ET ACCO CCOUNTING UNTING Total Finance Charges Regulatory Account 120 100 In $ Millions 80 60 40 20 0 Fiscal 2017 -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 22
ACC CCOU OUNTIN NTING G FOR FOR FDH FDH S USIN USING G MAR MARK-TO TO- MARKET MAR KET ACC CCOU OUNTIN NTING G - CON’T P&L – Regulatory Account Amortization of FDH Gain 40 In $ Millions 30 20 10 0 2020 2021 2022 Fiscal Year -$100 million in TFCRA amortized, assuming a 3 year test period in fiscal 2020 RRA 23
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