Fitch Ratings views TransAlta Corporation's (TransAlta) dividend reduction as a positive signal of management's commitment to deleveraging as the company faces unfavorable equity market conditions and energy price environment. The cash flow savings, about C$150 million annually, will alleviate medium-term concerns as TransAlta seeks to recalibrate its capital structure ahead of the expiry of power purchase agreements (PPAs) for its Alberta-based coal-fired generation assets.

A key driver of TransAlta's 'BBB-' Issuer Default Rating (IDR) is its debt-reduction commitment ahead of full transition of the Alberta energy market to competitive generation. Fitch estimates that adjusted-debt to EBITDAR of 3.25x is commensurate with a 'BBB-' IDR for merchant generators with a portfolio of at least 50% long-term contracted assets. Fitch uses proportional consolidation of 64%-owned TransAlta Renewables Inc. (TRI, not rated) debt and EBITDA to reflect increased subordination of TransAlta's cash flows to that of TRI's debt holders and equity investors. TRI is expected to grow to about 35% of TransAlta's consolidated EBITDA by the end of 2017.

Contrary to Fitch's expectations, TransAlta's consolidated adjusted debt rose by C$400 million during the first nine months of 2015 to reach C$4.9 billion at Sept. 30, 2015. The increase was mainly driven by a stronger US dollar, as TransAlta translates its fully hedged US-dollar denominated debt into its Canadian-dollar functional currency. Fitch estimates TransAlta's proportionate consolidated adjusted debt to EBITDAR at about 4.5x, pro-forma the cash proceeds from equity issuance and incremental asset dropdowns announced by TRI in November 2015, which is about 1x above the targeted level for year-end 2018. The combination of positive discretionary free cash flows and sharply reduced dividend payments should enable TransAlta to achieve modest incremental debt reduction in 2016-2018, without having to tap the equity markets. The ample liquidity and lack of debt maturities until June 2017 further supports the ratings.

Expected growth in non-recourse project-level debt will result in Fitch transitioning to a deconsolidated approach when assessing TRI. This approach recognizes that operating assets are encumbered by project-level debt that is structurally superior to parent-level debt. The residual cash flow available for upstream dividends and distributions is more volatile than the direct cash flow from wholly-owned unencumbered assets, and may be subject to payment restrictions under debt covenants or corporate bylaws.

EBITDA generation has proven resilient to depressed wholesale energy prices in 2014-2015 and is expected to remain close to C$1 billion annually in 2016-2017, helped by highly contracted cash flows and cost cutting initiatives. Nonetheless, Fitch views long-term downside risk to EBITDA generation as PPA and financial hedges roll-off. Hedge prices of approximately $50 per MWh in Alberta for 2016 exceed Fitch's long-term view for wholesale electricity prices in Alberta. Recently announced environmental policy in Alberta adds downward risk to our longer-term EBITDA forecast. Any lowering of Fitch sustainable EBITDA assumption post-2020 would have to be met with incremental debt reduction to maintain the current ratings and Outlook.

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