As many sectors face unprecedented disruption related to demand contraction and turbulent credit markets, our utility analysts are actively engaging with the companies we rate to discuss potential challenges utility management teams face. While utilities are not immune from the effects of the sudden deterioration of economic activity, they generally are well-positioned to ride out short-term demand shocks, including those associated with COVID-19. Utility companies operating in the U.S. and Canada benefit from some of the most credit-supportive business models of any issuers rated by S&P Global Ratings. A well-run utility will typically earn a fair return on invested capital, and recover all of its costs, including debt service, thanks to the prevalence of cost-of-service rate-making and durable regulatory frameworks. These companies benefit from strong barriers to entry in the form of regulation over a service territory that effectively grants the utility monopoly status. Threats from competitors and substitute products are limited and utilities have demonstrated an ability to manage recent hurdles such as distributed generation and climate change. Still, weaker economic conditions related to COVID-19 have affected some utilities and as the realities of lost revenue comes into focus, we find they are facing unexpected incremental pressure on ratings.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Despite Favorable Regulation, Management's Aggressiveness Leaves Little Room For Unexpected Setbacks

Most utility companies will be able to manage the impacts of COVID-19, as existing recovery mechanisms and rate proceedings will allow management teams to recapture lost cash flow with little disruption to financial risk profiles. Bad debts from mandated and voluntary policies not to cut power to vulnerable ratepayers will add to utility pressures, but we expect that utilities will collect most of this through rate cases and the creation of deferred regulatory assets. Given this type of stability in the face of economic downturns, our ratings on regulated utility companies are among the highest in our Corporate and Infrastructure Ratings practices, and we take fewer adverse rating actions in the sector in times of economic turmoil. Of course, utility companies face credit risks, but they are usually not in the form of demand shocks that so often plague typical industrial companies. More often, downgrades result from poorly executed strategic plans, stretched financial profiles from expansion, adverse regulatory rulings, or pressure from operational stumbles.

We certainly do not contend that demand does not matter to utility credit risk: it can at the margin. However, we do not see the pronounced swings in demand typical of more cyclical companies. The extent to which reduced demand prompts ratings actions, which does not occur often, depends on the individual utility and its management of regulatory risk. The relative stability of demand during a recession reflects the essential nature of the commodities provided and the fact that residential customers typically account for the majority of sales. Industrial and commercial demand can vary more, but the picture remains relatively predictable overall. What really differentiates utilities during severe downturns is the consistency and transparency of regulation, which can protect utility top lines. Regulation around the U.S. and Canada varies widely but many regulators have provided support to utilities from demand shortfalls related to conservation or weather, in the form of mechanisms that decouple revenue from sales, formula rate-making, or through other regulatory processes that enable utilities to defer costs for future recovery. In fact, it is because of conservation and the need to manage their businesses without volumetric growth for the last decade that the industry benefits from many favorable regulatory mechanisms. With respect to the current situation, we expect most utilities will be allowed to defer and collect the costs associated with COVID-19 through existing regulatory protections or future rate cases, although the timing and extent of these protections adds uncertainty to already stretched financial profiles.

Table 1

This added uncertainty is really the focal point for our analyses as we update our models for 2020-2022 to reflect the severe U.S. recession in the second quarter of 2020 and a recovery in the second half of the year. As we've noted, many utilities already face rating pressure due to a confluence of factors, including the adverse impacts of tax reform of 2019, historically high capital spending of about $150 billion per year, and associated increased debt levels. These factors have resulted in an unusually high percentage of negative outlooks for the sector. As of March 31, 2020, the percentage of issuers with negative outlooks was near 20% (reduced from 25% in late 2019).

Complicating matters is that capital markets will likely remain choppy. The sector's heightened reliance on high equity offerings last year could be constrained due to COVID-19 and new debt issuance has surged in recent weeks as utilities placed historically high levels of additional debt for refinancing and liquidity purposes. The good news is that the debt markets have absorbed new investment-grade issuances, which alleviates immediate concerns about liquidity. The not-so-good news is that this may weigh on some balance sheets and stretched financial profiles. In the end, these issues may test individual companies' financial policies and reveal the amount of risk they are willing to carry without compromising the sector's efficient access to capital.

Stability May Have Set A Financial Policy Trap For Some Companies

The essential nature of utility services, including electric, natural gas, and water, and the strength of the regulatory frameworks across North America breeds a level of confidence that enables utility management teams to dial-in risk management in most business environments. They are accustomed to running with negative free cash, and many have adopted policies that target a level of financial leverage that is just above the downgrade thresholds we communicate in our research reports. Under normal conditions, this is manageable, and the stability of these businesses enables companies to do that with a high degree of success. However, the incremental challenges brought to bear during this pandemic have already tested the prudence of stretching the financial profile as a consistent business policy. Leverage enables companies to grow and realize attractive returns as long as it is managed to optimal levels. The uncertainties related to COVID-19 have come on quickly, primarily from the commercial and industrial customers facing unprecedented business shocks, high unemployment, and from the downturn in nonregulated activities such as midstream energy and other services. Other pressure in the form of regulatory risk on the timing and extent of recovery related to COVID-19 costs such as bad debts, and swelling pension exposures add to the mix. For a few stretched issuers, the incremental challenges have already resulted in rating actions. For others, financial policy priorities may need reevaluation to solidify financial profiles and avoid credit deterioration, while many others will ride out the current downturn.

Some Utilities Have Limited Financial Cushion To Downside Triggers

Given the above, we believe that ratings pressure will remain to the downside through the 2020-2021 timeframe. The current high proportion of negative outlooks highlights that downside risks outweigh upside potential and a review of our existing projections for these companies only heightens concerns. A review of our projections for rated utility holding companies across the sector reflects the reality that tight cushions to downside triggers will likely persist. This sets the stage for downgrades to outpace upgrades for the near future, possibly lowering the median rating into the 'BBB' category for the first time in years. For many companies we rate, the forecast funds from operations (FFO) to debt ratio for the 2020-21 period is expected to reflect limited cushion above the downside trigger set in our published research. While that certainly does not mean that all of these companies will face downgrades, because some will begin to recover post-recession and others will take steps to address temporary weakness, it does highlight a tightening level of financial performance in an uncertain economic environment. With that said, we believe that management teams generally remain mindful of the benefits of maintaining stable credit quality and managing risk, and will take countermeasures to offset financial profile weakness.

Options Abound For Utilities, But Many Involve Unattractive Tradeoffs

Fortunately, most utility management teams have the ability to pull levers to target financial outcomes. While this is true in any sector, utilities' operating stability supports a greater degree of precision when managing financial risk against other stakeholder objectives. The capacity and willingness to take actions to offset the negative impacts of the current business environment will vary from company to company. So what options are available and at what costs? They include a range of choices including debt issuance (which may pressure credit measures) to reducing dividends and share repurchases (which may hurt share prices). We've highlighted some of the actions available to utility management teams and the costs associated with each (see table 2).

Table 2

These steps are part of any utility's toolkit in seeking to secure an optimal capital structure for its business, but the COVID-19 recession is likely to add some urgency to reconsider alternatives. Others may even learn from the crisis, reassess their financial policy targets, and decide to sacrifice some growth or profit potential for the long-range benefit of preserving financial cushions necessary to support credit quality.

Utilities Seek Best Outcomes In A Down Economy--And Look Forward To Better Times

As COVID-19 sets the stage for a challenging year for utility sector credit quality, we remain reasonably optimistic that management teams will commit to credit quality to limit negative rating actions. Fortunately, for utilities, options remain available and most regulators are likely to support recovery of bad debts and lost revenues in one form or another. The painful reality is that COVID-19 came at a bad time for everyone, including utilities that already faced more potential ratings actions then is typical. For the most strained issuers, or those that may not fare as well in front of regulators vis-à-vis COVID-19 costs, this is where the rubber will hit the road in terms of evaluating financial policy priorities. Companies will have to consider tough tradeoffs, and some may even need to take proactive steps to forestall rating downgrades. The good news is that most utilities have some ability to influence that outcome because the demand for utility services is relatively stable, even in a pandemic.