Tacoma, Washington; Retail Electric

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1 Primary Credit Analyst: Jeffrey M Panger, New York (1) ; jeff_panger@standardandpoors.com Secondary Contact: Peter V Murphy, New York (1) ; peter_murphy@standardandpoors.com Table Of Contents Rationale Outlook Business Profile Related Criteria And Research MAY 1,

2 Credit Profile US$ mil elec sys rev and rfdg bnds ser 2013A&B due 01/01/2042 Long Term Rating AA/Stable New Tacoma elec sys Long Term Rating AA/Stable Affirmed Rationale Standard & Poor's Ratings Services has affirmed its 'AA' rating on Tacoma, Wash's electric system revenue bonds. Tacoma has pledged its net electric system revenues to pay all principal and interest due on the bonds. The rating reflects the utility's: Favorable power supply position with surplus capacity in nearly all months, even under low stream flow conditions and below-average power supply costs; Strong liquidity; Very low rates and strong competitive position both regionally and nationally; and Manageable and rapidly amortizing debt levels, and moderate capital needs. Credit concerns include: Although debt service coverage (DSC) is solid at roughly 2x, fixed-cost coverage, which factors in transfers and fixed costs associated with purchased power, has weakened over the past three years, to levels that are not supportive of the current rating. Management's projections that fixed-cost coverage will stay at this level (assuming average water conditions) over the next couple of years and improve thereafter, coupled with strong liquidity and future flexibility associated with rapidly amortizing debt, help to mitigate, but not eliminate, this concern; The moderate hydrology risk associated with reliance on wholesale sales from Tacoma's long power position; A somewhat concentrated economic base -- industrial customers accounted for almost two-fifths of retail sales revenues, although down from historical levels. Tacoma Power's business profile score of '4', on a '10'-point scale with '1' representing the least risk and '10' the highest risk, reflects the utility's: Low-cost power supply and competitive rates; and Average operating risk of its power supply, distribution, and telecommunications operations. Tacoma's financial profile has historically been strong, though, we note, weakening over the past several years as low energy prices reduced off-system sales revenue and margins. DSC has been strong at roughly 2x, but fixed-cost coverage has been in the 1.25x-1.3x range over fiscal years , and is projected to remain so over the next three years. We note that these metrics are significantly weaker than the 1.5x-1.8x range posted from While these levels are not generally in keeping with the current rating, our concern is mitigated by strong liquidity (unrestricted cash measures 308 days of operating expenses) and budgeting which assumes adverse water conditions, MAY 1,

3 which we view as conservative. We believe that maintenance of strong liquidity is essential given exposure to fluctuations in hydrological conditions and their potential effects on the utility's finances. Tacoma's electric system is not unduly leveraged. Debt to capitalization is healthy at 41%. Roughly two-thirds of outstanding debt amortizes by 2020, when carrying charges decline from about $60 million per year to about $40 million, inclusive of a planned debt issuance in 2015 and 2017, giving Tacoma future financial flexibility. The utility's five-year capital plan totals $439 million, with 57% ($253 million) to be funded with debt (including $94 million from the series 2013 bonds and $159 million of future financings). Tacoma raised rates 5.8% for fiscal 2011 and an additional 5.8% in fiscal 2012, the first such increases since Despite these increases, Tacoma's rates are likely to remain very competitive in the region. According to the U.S. Department of Energy's Energy Information Administration, Tacoma's systemwide rates were about 15% below the state average in 2011, the most recent year of comparative information. We believe that this competitive advantage provides the utility rate-raising flexibility. Tacoma is long on power -- in 2012, about 60% of energy sales were to native customers, while 40% was off-system. Only 14% of operating revenue came from off-system sales in 2012, down from 22% in 2010, and 27% in Margins on off-system sales have thinned in recent years as market prices have declined in response to the falling price of natural gas. However, the utility's low cost of power has helped preserve some of the margin that has disappeared in many parts of the country. Load growth has tapered off during the recession and ensuing recovery, and is projected to be a modest 0.9% over the next five years. Sales to industrial customers are a substantial 53% of retail sales (32% of total sales), exposing the utility to potential demand fluctuation. Residential customers account for 40% of retail sales (24% of total sales). Although there is industrial concentration, the base is generally broad, with the top 10 customers accounting for 17% of sales. Reflecting a large military presence (Fort Lewis and McChord Air Force Base), median household effective buying incomes are only 92% of the U.S. average. Outlook The stable outlook reflects Tacoma's favorable power supply portfolio, which should enable it to maintain a solid cash position. We are concerned about fixed-cost coverage not in keeping with the current rating, but believe that the city's favorable cash position and low cost of power provides the utility with financial flexibility. However, should actual fixed-cost coverage fail to meet projections, we would likely lower the rating. We do not envision credit improvement over the next two years. Business Profile Tacoma Power's business profile of '4' reflects: The willingness of, subject to city council approval, the utility's board to promptly exercise its rate-setting authority; The utility's access to retail markets with below-average demographics and moderate industrial concentration; An average operational risk due to moderate hydrology risk; The utility's wholesale operations; and MAY 1,

4 The utility's rates, which are very competitive, in our view, and low power supply costs -- Tacoma, however, is exposed to potential power cost increases because of its association with Bonneville Power Administration (BPA), which supplies the utility with 52% of its power. Finally, the business profile score also reflects some business risk inherent in Tacoma's telecommunications venture, the Click! Network, which is subject to a high degree of product and service competition. The Click! Network business line offers retail cable service, business telecommunications, and Internet access through Tacoma's fiber-optic network. Rate autonomy, the direct competition for customers, and an operational risk due to its high upfront capital requirements characterize Tacoma's telecommunications business line. Its telecommunications business depends, in large part, on the electric infrastructure, which reduces the operating risk. Markets Tacoma Power's 180-square-mile service area includes the 43-square-mile area within Tacoma's city limits. Tacoma also serves McChord Air Force Base, Fort Lewis Military Reservation, and the towns of Ruston and Fircrest. Retail sales totaled 4.75 million megawatt-hours (MWh) in 2012 and off-system sales totaled 3.1 million MWh, while peak demand was 923 MW in The city's high 60% load factor reflects its substantial industrial base. The city projects total retail sales increasing modestly over the next five years, by 0.9% per year. Tacoma's economy has historically been concentrated in shipping, manufacturing, timber production, and the military. Two military bases, public agencies, and hospitals top the list of the area's leading employers, which also includes such private employers as Fred Meyer Stores, Intel Corp., Emerald Queen Casino, and Boeing, most of which are also electric system customers. Median household effective buying incomes were about 92% of the national average. Operations Tacoma Power benefits from a low-cost resource mix largely derived from owned and purchased power from hydroelectric assets. Power resource costs averaged about 1.8 cents per kilowatt-hour (kwh) in Purchased power accounts for 59% of energy needs. The utility largely derives its purchased power under a block (190 amw) and slice (253 amw under median water conditions) contract with BPA that expires in Owned resources are also hydro-based. Most of the units are relatively small, varying from 12.8 MW to 56.0 MW; the Cowlitz River project is the exception, with a nameplate capacity of 462 MW at two dams. Owned hydro projects have received license extensions from FERC; the earliest expire in Power costs at Tacoma's projects averaged less than two cents per kwh in 2012, which provides a strong underpinning for its overall competitive position. Tacoma's power portfolio provides an opportunity for significant wholesale sales under most stream flow conditions. During , depressed wholesale power prices in the region significantly reduced wholesale revenues, as compared to fiscal years Management A public utility board governs the electric system, and appoints the director of public utilities. Rate setting, the issuance of debt, and other matters require formal city council approval. City officials have generally demonstrated a commitment to sound financial performance by quickly increasing rates when rising costs indicate it is necessary to do so. This was particularly evident during 2000 and 2001, when Tacoma MAY 1,

5 adopted a temporary 50% rate surcharge in response to rising purchase power costs to preserve its financial position. Management's rate strategy targets rate stability for its customers, which led its decision to hold rates in place during the and budget deliberations. However, Tacoma increased its rates by an average of 5.8% in both 2011 and 2012, and 4.2% in 2013 to maintain sound margins while debt service requirements increase, and to meet its target capital financing ratio of 50% for major capital investments. Bond provisions A senior-lien pledge on net revenues of the electric system and any money credited to the revenue fund or any bond fund secure the bonds. A debt service reserve (DSR) fund equivalent to the lesser of maximum annual debt service (MADS), 1.25x average annual debt service, or 10% of par provides additional bondholder protection. The governing ordinance requires that rates be set to recover sufficient net revenues to provide 1.25x annual DSC. Tacoma Power officials, however, have established an internal policy that budgets for minimum DSC of 1.5x. Additional debt can be issued with a certified independent engineer's report that projected net revenues will be sufficient to provide 1.25x MADS. A DSR fund will be funded at MADS on the closing of the bonds, but utility management retains the right to fund the reserve over a five-year period. Under the amended bond resolution, the DSR requirement has now become optional, since the series 1992B, 1994, and 1997 bonds are retired. We do not currently view the absence of a DSR from debt as a concern because Tacoma has historically maintained strong on-balance-sheet reserves. Related Criteria And Research USPF Criteria: Electric Utility Ratings, June 15, 2007 Ratings Detail (As Of May 1, 2013) Tacoma elec Unenhanced Rating AA(SPUR)/Stable Affirmed Many issues are enhanced by bond insurance. MAY 1,

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