Fitch Ratings has affirmed at 'A' the following Indianapolis, IN revenue bonds (issued on behalf of the Board of Directors of its Department of Public Utilities, dba Citizens Energy Group).

$67 million outstanding thermal energy system first lien revenue bonds series 2013A, 2014A, and 2016A.

The Rating Outlook is Stable.

RATING ACTIONS

Entity / Debt

Rating

Prior

Indianapolis (IN) [Citizens Energy - Thermal Energy]

Citizens Energy Group (IN) /Thermal Energy System Revenues/1 LT

LT

A

Affirmed

A

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VIEW ADDITIONAL RATING DETAILS

SECURITY

The bonds are secured by a first lien on net revenues of Citizens Thermal Energy System (Citizens Thermal), which consist of steam and chilled water sales and certain other pledged funds under the master indenture.

ANALYTICAL CONCLUSION

The affirmation of Citizens Thermal 'A' rating reflects the system's stronger financial profile, characterized by consistently strong operating margins, which has allowed the utility to pay down its long-term debt and cash fund its capital investments. This results in a very low leverage calculation of 1.3x in 2022. However, the rating is also reflective of significant revenue concentration within the top 10 customers, comprising approximately 86% of total operating revenues, as well as rate regulation of the steam system. The top 10 customers are a mix of university centers, governmental agencies, and large corporations, with the majority of the contracts containing one-, five-, or 10-year auto-renewal clauses.

KEY RATING DRIVERS

Revenue Defensibility: Midrange

Revenue defensibility is constrained at midrange due to a very concentrated customer base with the top 10 customers accounting for approximately 86% of combined revenues and due to rate-regulated revenues for the steam business. However, the utility benefits from the competitive advantage of operating in a dense metro service territory with favorable pricing, including high alternative provider costs that make competition unlikely. The utility has engaged in multiple negotiations for various growth opportunities that are expected to begin service in the next few years.

Operating Risk: Stronger

The system's stronger operating risk assessment is driven by midrange cost flexibility and stronger resource management with further planned capital investments to address growth initiatives.

Financial Profile: Stronger

The system's financial profile is assessed as stronger. Leverage continues to decline as the system pays down debt and maintains consistently strong margins. Liquidity is down slightly over the past five years, with 129 days of cash on hand from 171 days in 2018, but is up from 114 days in 2021. Coverage of full obligations is healthy at 1.7x. Additional borrowing capacity increases overall liquidity to 212 days. The financial profile, while stronger, is less of a consideration in the final rating given minimal debt, as well as the above discussed revenue concentration that constrains the overall rating.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Continued measurable decline in leverage, notwithstanding the continued rating constraint imposed by customer concentration and the potential loss of customers, given the limited nature of the business.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Insufficient rate recovery that leads to a substantial measurable decline in financial metrics and reduces financial flexibility.

A loss of a top customer and a resulting strain on margins and increase in leverage.

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

CREDIT PROFILE

Citizens Thermal provides regulated steam and unregulated chilled water services for commercial and industrial heating and cooling to 131 steam and 66 chilled water customers in Indianapolis' central business district.

The thermal system is a division of the city of Indianapolis' (the city; AAA/Stable) Department of Public Utilities, doing business as Citizens Energy Group. Citizens is the trade name under which the city, by and through the board of directors of the department of public utilities, provides a range of utility services to customers in and around the city. Citizens, including the wastewater system owned by CWA Authority, Inc., has six standalone utility segments that are each rated in the 'A' category by Fitch.

The steam and chilled water funds are separately reported in Citizens's financial audit but issue debt on the combined thermal system security. Fitch's analysis is based on the consolidated financial metrics of the steam and chilled water funds.

Revenue Defensibility

Revenue defensibility is mixed given the weaker demand characteristics, with midrange pricing characteristics. Revenue defensibility and upward rating potential is limited by the system's small customer base (just 131 steam and 66 chilled water customers) and high concentration of revenue among the top ten customers.

Favorably, the customer base has been very stable and the largest customers are well-established entities that are likely to continue to anchor the Indianapolis economy, including Indiana University Purdue University Indianapolis (IUPUI), Eli Lilly, Indiana University Health, and Eskenazi Hospital. A number of growth projects have been solidified with several large load customers. Service is expected to begin in the next few years. Additional opportunities are also being pursued.

Most of the utility's top customers are signed to contracts of varying terms, with most expiring within 10 years or less and prior to the maturity of the bonds (final maturity 2034), adding renewal risk. The high costs of switching to self-generating services, including capital expenses, operation and maintenance costs, and building space requirements, are substantial and help ensure an adequately reliable revenue stream that somewhat offsets contract renewal risk.

Sustained customer retention trends will remain an important rating factor. Only one customer elected against renewal among the top ten customers for both steam and chilled water, with their current contract expiring on Aug. 31, 2028. The departing customer accounts for approximately .4% of combined revenue.

Fitch believes these risks are partially mitigated by the system's competitive rates and the prohibitively high costs customers face switching to in-house services. Demand is primarily influenced by the number of heating and cooling days in a year given the essentiality of business heating and cooling in Indianapolis. Variability in steam load is partially stabilized by the quantity used in pharmaceutical manufacturing at the largest customer, Eli Lilly. Demand for chilled water is primarily influenced by outside air temperature.

Midrange Pricing Characteristics with Partial Rate Regulation

Rates for the steam customers are regulated and set according to the Indiana Utility Regulatory Commission's (IURC) rate regulations and tiered tariff schedule, while rates for the chilled water customers are bilaterally contracted with specific annual escalators tied to certain U.S. Department of Labor indices. Citizens has a strong track record of timely and successful execution of periodic rate cases for all of its rate-regulated utilities, including the steam system, which accounts for the majority of thermal system revenue (though a smaller portion of operating margin than the unregulated chilled water division).

Steam system customers are distributed into three tariff rate classes set under the IURC's 2016 rate order. Steam rates include temperature adjusters and quarterly fuel cost adjustments to recover changes in estimated fuel costs, which Fitch believes contributes to the midrange assessment for the legal framework to recover commodity price volatility and offset some level of inflationary driven cost increases. Under Indiana Code (*) 8-1-2-42.5(a), rates are reviewed by the IURC at least every four years to ensure they meet operating and debt service costs among other reasonable charges to keep the system in sound physical and financial condition. The steam system filed a base rate case on March 1, 2023 and is expecting an order in the proceeding by the end of 2023.

Unregulated chilled water is sold to retail customers pursuant to bilateral contracts with varying terms for renewal and cancellation. Rates are generally fixed plus variable usage charges.

Operating Risk

Operating cost flexibility is considered midrange as the ability to vary marginal cost with fluctuation in demand is somewhat limited given the fixed costs associated with supplying steam and chilled water. Positively, the more variable cost drivers like commodity costs shift with demand and are recovered in regular fuel cost adjustments.

Steam System Resource Management

Roughly 65% of the system's steam is purchased (Covanta long-term contract) and the rest is produced at two owned steam productions facilities centered around downtown Indianapolis in a portfolio of established and aging boilers. System assets appear reliable, have a long history of operations, and have all been converted to natural gas-fired boilers. Management believes both systems have ample capacity and redundancies. In addition, the steam system boiler conversion to natural gas from coal (Perry K plant conversion) has lowered operating and long-term capital costs (including costs related to emissions), leading to greater projected free cash flow and more consistent financial performance.

The steam system serves the Indianapolis central business district through its Perry K Plant (serves about one-third of needs), a smaller chiller boiler plant to serve Eskenazi Hospital with steam and chilled water, and purchases pursuant to a long-term contract (through 2028) with Covanta. Citizens Thermal is obligated to purchase all of the available steam production from the Covanta plant and Covanta is obligated to provide at least 29 million therms during the term of the contract. This provides the thermal system with excess capacity to meet all system needs.

Citizens Thermal converted the Perry K plant to run on natural gas in 2015 from coal for cost savings and to address the EPA's industrial boiler regulations. Approximately 95% of the plant's water needs come from the nearby White River. Four generating facilities power the Perry K plant, currently with a combined operating capacity of 10.6MW. The house generator (5MW) supplies substantially all of the required power to operate the plant. Generation from the other facilities and a backup agreement with Indianapolis Power & Light can be used to manage peak plant loads.

Chilled Water System Resource Management

The unregulated chilled water system has ample combined capacity totaling 59,200 tons for chilling services to meet a peak load of about 46,500 tons in 2022. The primary source of cooling services is the West Street System, one of the largest district cooling systems in the U.S. The system serves 66 customers including Indiana Convention Center, Lucas Oil Stadium (home of the Colts), university and hospital facilities and a portion of Eli Lilly. The customer base is small but has diverse peak demand requirements. The West Street System consists of four main chilled water production facilities: the West Street Plant, the North Plant, the Illinois Street Plant, and the Chiller Boiler Plant.

Additionally, the chilled water system purchases approximately 8 million therms of steam per year from the steam division to fuel the system's water chillers.

Capital planning is considered neutral to the rating. Management reviews capacity requirements on an annual basis. The utility is currently pursuing or have solidified a number of growth opportunities that are expected to begin service within the next few years. Citizens reviewed the 2023 capital plan and decided to increase spend by approximately $2 million for the next four years which includes the growth projects in progress. The capital plan is expected to be funded by operating cash flows. Management indicated that capital spend may increase if additional infrastructure is needed for ongoing negotiated growth projects.

The combined system's estimated age of plant has remained stable at 22 years over the prior five years. Capital investment appears adequately addressed in the five-year capital improvement plan that totals over $65 million over the next five years, up from $48.5 million in the trailing five years.

Financial Profile

The utility's financial performance in 2022 was strong. The utility has been paying down its long-term debt, reducing debt from over $133 million in fiscal 2018 to roughly $83 million in fiscal 2022. As a result, leverage declined for the third year in a row to 1.3x, down from 2.5x in 2021. Total operating revenues in fiscal 2022 increased by $12.5 million YoY to $113 million, driven by increased sales volumes in both steam and chilled water. The utility continued to return historically strong margins, which has averaged 14% over the past five years.

The steam system contributes roughly 65% of total operating revenues but is a thinner-margin business than chilled water. In 2022, steam had a net income of $3.5 million (4.5% margin), while chilled water contributed $8.9 million of net income (23% margin).

Forward Look and Fitch Stress Scenario

With the amortization of debt and no new debt projected, cash (including investments restricted for debt service) could exceed debt by fiscal 2024, driving Fitch's net leverage ratio, which balances debt outstanding and net pension obligations again cash reserves, below zero. The utility expects net income to rise above historical levels in the $12-16 million range to above $20 million in 2024 and out.

The increased margin is primarily driven by increased base rates that are expected to be approved by the end of 2023, as well as a new service agreement with Eli Lilly, as the current contract expired at the end of 2022. The FAST shows an improving cash flow as a result. Citizens management indicated that operating cash flow will be used to fund a heightened CIP, which includes various growth projects. In Fitch's standard stress scenario, a two-year decline in demand in line with variability experienced in past stresses, produces a similarly healthy outcome and leverage ratios that will not pressure the stronger leverage and financial profile assessment of the utility.

The system's liquidity profile is neutral to the rating. The utility has 129 days of cash on hand, with about 75% of cash being held in the chilled water business. Total liquidity, which includes lines of credit, is ample at 212 days, and COFO is very healthy at 1.7x.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

Additional information is available on www.fitchratings.com

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