Lubbock, Texas; Retail Electric

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1 Summary: Lubbock, Texas; Retail Electric Primary Credit Analyst: Scott W Sagen, New York (1) ; scott.sagen@spglobal.com Secondary Contact: Theodore A Chapman, Dallas (1) ; theodore.chapman@spglobal.com Table Of Contents Rationale Outlook JULY 11,

2 Summary: Lubbock, Texas; Retail Electric Credit Profile US$ mil elec lt and pwr sys rev bnds ser 2018 dtd 08/01/2018 due 04/15/2048 Long Term Rating AA-/Negative New Lubbock retail elec Long Term Rating AA-/Negative Outlook Revised Rationale S&P Global Ratings revised its outlook to negative from stable and assigned its 'AA-' rating to Lubbock, Texas' $94 million series 2018 electric light and power system revenue bonds. At the same time, we affirmed our 'AA-' rating on the system's parity electric system revenue bonds. The system does business as Lubbock Power & Light (LP&L). The negative outlook reflects our view that the utility's 1.17x-1.24x fixed-charge coverage has been weak for the rating. In addition, management's financial projections indicate a decline in fixed-charge coverage to below 1.2x from fiscal years 2020 through Our fixed-charge coverage reflects our view that the utility's capacity payments to other generation owners are vehicles for funding the suppliers' recovery of their investments in generation assets serving LP&L. However, the utility has potential to transition to a new business model in 2021, which could enhance financial stability in future years because of the additional transmission revenue stream. It plans to grow its transmission business, which will provide access to higher returns that could bolster financial margins. LP&L is also exploring reducing its energy supply function role by allowing about 70% of its customers to select alternative energy providers. This latter proposal would maintain the distribution function that conveys electricity to its customers but would sharply reduce its obligation for securing energy supply and paying demand and capacity charges to others, which could strengthen the fixed-charge coverage ratio. Because it will be several years before the utility can realize the benefits of the customer choice and transmission investment strategies, we could lower the rating if its fixed-charge coverage metrics remain weak in the interim. In addition, we have affirmed our 'AA-' rating on LP&L, based on our opinion of its general creditworthiness, including: The 2010 agreement that effectively ended the door-to-door competition between LP&L and an investor-owned utility that had been in place since 1942, making LP&L the sole retail electric provider to virtually the entire service area, which translates into a more secure and predictable revenue stream and allows LP&L to have more certainty regarding long-term planning; The city's strong regional economy, anchored by higher education and health care, and the system's competitive weighted average system electric rates based on relative customer classes' revenue contributions; The utility's low-risk operations as a principally distribution utility that sources its customers' energy needs under a full-requirements purchased power agreement (PPA) through 2019 with Southwestern Public Service Co. (SPS), a subsidiary of Xcel Energy, which is also LP&L's former competitor; JULY 11,

3 The planned integration of 70% of the utility's load to the Electric Reliability Council of Texas (ERCOT) power grid by June 1, 2021, and the board's plans to study the feasibility of migrating customers to alternative energy providers and exiting the power supply business for the LP&L customers within the ERCOT footprint, but maintaining this role for the 30% of customers within the SPS footprint; Our belief that LP&L will face limited potential for stranded costs because of its modest generation assets; and Good liquidity position, because although liquidity levels are projected to decline through the financial forecast, we believe days' cash equal to at least 110 days' cash will be maintained through fiscal In our view, these credit strengths are partially offset, in part, by the system's: Low fixed-charge coverage metrics for the rating level equal to roughly 1.2x in fiscal years 2017 and 2016; and Additional debt needs as an approved transmission owner in the ERCOT market that is projected to more than double its debt burden by fiscal 2020 to a moderately-high $4,030 per customer. The bonds are secured by a first-lien pledge on the net revenues of LP&L's electric system. We understand series 2018 bond proceeds will fund primarily transmission-related capital projects, distribution projects, and customer information systems. The system has not entered into any direct-purchase bank debt. A business profile score of '4' on a '10'-point scale, with '1' being the strongest and '10' the weakest, reflects the system's position as a full-requirements PPA through 2019 with SPS, a subsidiary of Xcel Energy, which we believe limits operational risk. In addition, electric rates remain competitive when compared to the state average. The system's planned integration to ERCOT by June 2021 will likely lower capacity costs but also drive the capital program with significant transmission projects accounting for the majority of total needs. LP&L is in the Southwest Power Pool, a regional transmission operator that serves all or portions of 14 states, including the Texas Panhandle. Currently LP&L is a full-requirements customer of SPS by way of the city's participation in West Texas Municipal Power Agency (WTMPA), a joint-action agency that derives 95% of its revenues from the city. WTMPA's total requirements contract expires in May On April 9, 2018, LP&L's signed order from the Texas Public Utility Commission (PUC) was finalized to proceed with its integration into the ERCOT market by June 1, The majority of LP&L's customer base (70%) will transition from the Southwest Power Pool to ERCOT by If the city opts into retail competition following the board's feasibility study, we understand that LP&L plans to revise its business model and operate as a transmission and distribution utility for the ERCOT portion of its system. LP&L would continue to serve the 30% of its load that will remain in the Southwest Power Pool, but competitive energy providers could begin to meet the needs of customers in the retail competition area by Under this scenario, management projects LP&L will shed purchased power costs and related capacity costs beginning in fiscal 2021, but weaker financial metrics are projected primarily due to planned one-time hold harmless payments to SPS totaling $24 million. If the utility chooses to opt into retail competition, it is our understanding that the retail electric providers (REP) will remit transmission and distribution charges they have collected on LP&L's behalf to LP&L on a monthly basis. In order JULY 11,

4 to ensure timely payment to LP&L each REP must meet certain financial standards of the Texas Public Utility Commission (PUC) applicable to electric service providers. It is currently unclear what those standards entail as contracts have yet to be entered in to. In an opt-in scenario, officials believe LP&L will not be selected as the provider of last resort. Should no other provider step-in for that role and LP&L is selected as the POLR we do not consider it to be a credit concern because we believe LP&L would pass through the costs of market power to these customers. We expect limited potential for stranded costs totaling an estimated $4.2 million in fiscal 2021 because of LP&L's modest generation assets. We believe LP&L could recover these costs by issuing debt or through its rates. It is also important to note that LP&L fully pays off its SPS debt in April 2020 before the planned integration to the ERCOT power grid. LP&L currently has 112 megawatts (MW) of dependable natural gas-fired generation, with 112 MW anticipated to be available in 2019 for load requirements. Officials project the city will require an estimated 626 MW of total generation in 2019 for load requirements. LP&L has a bilateral agreement directly with SPS, beginning in June 2019, to become a partial requirements customer for 170 MW through LP&L through its participation in WTMPA entered into a PPA with Elk City II Wind LLC for 96 MW of wind energy from June 2019 through May In addition, it entered into a capacity and energy scheduling contract with SPS for 400 MW from June 2019 through May 2021 that will allow LP&L to purchase most of its energy needs from the Southwest Power Pool Integrated Marketplace. Management's current financial projections indicate a declining trend in fixed-charge coverage to below 1.2x from fiscal years 2020 through 2022, reversing the recent improvement in fixed-charge coverage since fiscal 2014 to an anticipated 1.3x projected for fiscal However, we note management's conservative assumptions included in its financial forecast could result in better-than-projected results. The potential decline in fixed-charge coverage in fiscal 2021 reflects one-time hold harmless payments to SPS in 2021 related to the utility's planned integration to the ERCOT power grid for a portion of its load. LP&L's transmission revenue stream beginning in fiscal 2021 and totaling an estimated $36 million by fiscal 2022 will provide additional revenue diversity and predictability because all of the ERCOT area's transmission system users will essentially be LP&L's transmission customers. Transmission rates are approved by the PUC and are based on a transmission cost-of-service filing that includes a return on investment. Also, the regulatory framework socializes the transmission system's costs and the return across the nearly statewide system. We consider LP&L's financial position just adequate at the current rating level and it is strengthened by a good liquidity position that we believe to be sustainable. Following a 5.75% rate increase, fixed-charge coverage was a still-low 1.24x in fiscal 2017, equal to its metric in fiscal 2016 and an improvement from just below 1.2x in fiscal years 2015 and Following a 5% rate increase, officials project to maintain an improved 1.3x for fiscal 2018 and a good 1.3x in fiscal Fixed-charge coverage is S&P Global Ratings' internally adjusted debt service coverage calculation that treats fixed demand charges as if they were on-balance-sheet debt and general fund transfers as if they were part of operating expenses. We consider the system's liquidity position to be a credit strength, steadily improving to $67 million, or a strong 125 days' cash on hand in fiscal Although management forecasts declines in liquidity as it cash funds certain hold JULY 11,

5 harmless payments, we believe levels will remain good, equal to at least 110 days' cash on hand through fiscal According to the Department of Energy's Energy Information Administration (EIA), LP&L's weighted average electric system rate competitiveness (based on relative customer classes' revenue contributions) is a competitive 89.4% of the state average in 2016, the most recent year of available comparative data. We also note that residential rates are 7.6% below the state average while commercial rates are 13.9% below it. Management raised utility base rates 5% in October 2017 (lower than the 5.75% originally projected). In addition, the financial forecast no longer includes a rate increase in The proposed new flat residential rate will change the seasonal fixed energy costs to an annual rate meant to lower customers' bills in the summer. We will continue to monitor LP&L's planned integration to ERCOT; decisions supporting consistent financial performance, including rate adjustments, will also play a part. Management has in place, and automatically semi-annually adjusts its fuel/purchased power cost adjustor with any power cost recovery also absorbed by a rate stabilization reserve. Management still reserves the right to implement a pass-through adjustment outside of the automatic semi-annual adjustments should LP&L become under-recovered beyond its target level. A debt service reserve fund in the amount of average annual debt service provides additional liquidity; however, a surety policy can be used to satisfy the reserve fund requirement, a new provision as of Also introduced in the 2013 master resolution was a revision to additional bonds language to a historical 1.1x maximum annual debt service (MADS) coverage test. A rate increase implemented within 60 days of the bond issuance may be permitted to be applied to projected revenues to meet the additional bonds test. There is no change to the sufficiency rate covenant. The system's debt burden will rapidly increase to moderately high levels in 2020 because it plans to issue a combined $267 million in additional debt related to constructing transmission assets in 2019 and The system's debt burden will increase to an estimated $4,030 per customer in 2020 from just $1,214 per customer in Following the series 2018 debt issue, the system will support $196 million in total debt, including general obligation (GO) or certificates of obligation debt. LP&L's six-year capital improvement plan (CIP) has identified about $387 million in total projects through fiscal 2024; the bulk of identified projects are transmission-related and occur in 2019 and LP&L intends to debt finance the majority of its current CIP. LP&L currently serves 105,788 metered accounts. The city, home to approximately 249,042 people, is in west Texas and acts as a regional trade and service center for a 25-county region with a population of about 600,000. The city's economy includes strong education and health care sectors. Lubbock's economy is anchored by Texas Tech University, which has an estimated enrollment of 35,000 and is the city's largest employer with approximately 9,000 employees. In our opinion, median household income levels are adequate at 85% of the national level in 2017, in part reflecting the large student population. LP&L is not reliant on any of its principal customers for operating revenues, with its 10 leading customers accounting for a diverse 16% of total revenues in fiscal Outlook The negative outlook reflects our view of the utility's historically weak fixed-charge coverage at the current rating with the expectation of weak fixed-charge coverage levels over the next five years. If the utility's fixed-charge coverage JULY 11,

6 metrics decline as projected in the near term and remain an outlier for the current rating, we could lower the rating. Over the long term, we believe the utility's transmission investments integrated into the ERCOT power grid will provide for an attractive rate of return and could improve financial metrics. Downside scenario We could lower the rating if fixed-charge coverage metrics do not strengthen during the two-year outlook horizon. The utility has the potential to strengthen financial metrics as the business model evolves and it sheds demand and capacity charges that erode fixed-charge coverage while adding transmission assets that can garner strong returns. However, it will be several years until this transition is complete. Upside scenario We could revise the outlook to stable if the utility's 2018 and 2019 financial performance strengthens. In addition, we view the utility's potential opt-in scenario as a net positive because it could provide more stable revenues, as it removes the risk of providing the power supply function to a portion of its customer base and invest in its transmission business, which should improve financial margins over the long term. 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 for further information. Complete ratings information is available to subscribers of RatingsDirect at All ratings affected by this rating action can be found on S&P Global Ratings' public website at Use the Ratings search box located in the left column. JULY 11,

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