In a cautious investment environment, North American utilities remain comparatively better positioned to manage higher interest rates in 2023 than the private energy infrastructure sector, according to recent reports.
Heading into the new year, the utility sector faces acute challenges in the form of soaring commodity prices pressuring customer bills, resulting in political and regulatory pushback and heightening overall credit risk for the sector. But the interest rate environment should prove manageable, thanks to hedges in place that mitigate exposure to Federal Reserve hikes.
Bond analysts at CreditSights do not expect any utilities to take on debt that would result in the holding company rating falling from mid-BBB to low BBB, which is one notch above junk, according to a pair of 2023 outlook notes, despite utility management teams' "strong aversion" to issuing equity as they strive to hit 5%-7% EPS growth targets.
Although several rating agencies have issued less than sunny outlooks for the utility sector in 2023, CreditSights noted the ratios of several utilities' funds-from-operations-to-debt are trending positive and many utilities are maintaining stable EPS estimates, making negative regulatory and political headlines "manageable."
"When most utilities let holdco ratings slip from high to mid BBB it cost them 10-15 [basis points] in financing costs, but moving to low BBB in the current market would cost another 40 [basis points]," CreditSights analysts wrote, "and we don't see any utility management team wanting to pay an extra 40 [basis points] in a rising rate environment."
At least 13 holding companies have hundreds of millions in debt maturing during the first half of 2023, according to S&P Global Market Intelligence data, but refinancing is not expected to be an issue as most large utilities are well-hedged against rate exposure.
Regarding utility bond yields, CreditSights expects DTE Energy Co., Entergy Corp., American Electric Power Co. Inc., FirstEnergy Corp., Duke Energy Corp. and PPL Corp.'s funding arm to outperform the sector, with Berkshire Hathaway Energy, NextEra Energy Inc., Avangrid Inc. and Dominion Energy Inc. forecast to underperform.
CreditSights also noted deferred higher energy costs are dragging on Duke's and Dominion's credit profiles.
One tool utilities have leaned on for capital needs without issuing debt or equity has been divestment of regulated assets or stakes in those assets. But rising interest rates have dampened private equity firms' interest in acquiring utility assets, Mizuho told clients Jan. 9, amid a "cooling off period" for such transactions. That could prompt companies like Black Hills Corp. to reconsider plans to shop a minority interest in its gas utilities to fund equity needs.
On the equity side, Mizuho continued, "it is our view that utility valuations are not fully discounting the macroeconomic backdrop for 2023 of slow-to-negative growth and rising rates." The investment bank's "defensive" stock picks are DTE, CMS Energy Corp., Xcel Energy Inc. and CenterPoint Energy Inc.
Private fundraising headwinds
Privately owned energy infrastructure, on the other hand, may not be as well-positioned to weather the coming year in debt markets.
The broader infrastructure industry, which includes assets ranging from telecom to airports as well as energy, saw "record fundraising, strong performance and steady valuations in 2022," analysts at UBS wrote in a 2023 outlook report. But "there will be greater divergence across winners and losers" in 2023, in the view of UBS, as affordable financing dries up and investment exit values tied to corresponding public sectors decrease.
Renewable energy investment and production tax credits introduced in 2022's Inflation Reduction Act "turbocharged" private equity infrastructure firms' options for deploying funds to the industry, experts told S&P Global Commodity Insights in recent interviews, but fundraising could be more difficult in 2023.
"Infrastructure cash flows may prove to be as resilient as advertised, and valuations may remain stable since there is little change in discount rate or earnings, but opportunity cost is still an issue," UBS wrote. "When an investor can buy a 10-year U.S. Treasury Note and get a 4% yield, a super-core strategy with limited inflation protection that generates a (hypothetical) 6% net return would appear less compelling."
Still, rising prices for renewable energy power purchase agreements are helping private equity firms protect returns in a high interest rate environment.
Average U.S. prices for large-scale solar rose 30.3% year over year to $42.21/MWh in third-quarter 2022, while wind power purchase agreements jumped 37.4% to $49.66/MWh, according to an October 2022 LevelTen Energy Inc. report.
"If you look at our existing renewable energy fleet, 90% of our [investments] are project-level based and they've got 12 years of life remaining, so we're pretty well-protected from increasing interest rates in our existing portfolio," Julian Thomas, a managing director and head of strategic initiatives in Brookfield Asset Management Inc.'s renewable power and transition group, said in a recent interview.
The private equity giant in June 2022 closed its $15 billion Brookfield Global Transition Fund, which will inject cash into companies focused on deep industrial decarbonization that already have the technology and intellectual property while allowing management teams to maintain control.
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