(Editor's Note: On June 9, 2020, S&P Global Ratings--together with S&P Global Platts Analytics and S&P Global Market Intelligence--hosted a webcast to discuss its outlook for the U.S. and European power markets. This FAQ was adapted from that discussion. The viewpoints of S&P Global Platts Analytics and S&P Global Market Intelligence appear in shaded boxes. All other responses are from S&P Global Ratings. S&P Global Ratings, S&P Global Platts Analytics, and S&P Global Market Intelligence are separate, independent divisions of S&P Global.)
With the ongoing transition toward renewable energy sources, weakening load growth, and declining fuel prices, power generators worldwide had already been facing a more uncertain period prior to the emergence COVID-19. The pandemic has changed things further and has accelerated some of these trends. The lockdown has led to a decline in power consumption, with an associated reduction in market power prices. Moreover, it has caused delays in a number of new generation projects.
As discussed in our recent webcast (see link below), many of these developments have put a strain on the creditworthiness of power producers. However, in our view, the credit risk for U.S. IPPs is somewhat mitigated by their operational diversity and countercyclical retail power operations, which provide a hedge. And while the disruption is worse in Europe because of lower demand and low power prices, the financial impact on our rated European power generators has generally been manageable so far this year. This is largely because of price hedges. The impact will be greater over 2021-2022, as the hedges are lower and the forward prices weaker than we anticipated last year. Although we expect the effects of these factors to be temporary, the credit risk for projects fully exposed to wholesale power prices has increased.
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S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
S&P Global Market Intelligence notes that while merchant spark spreads are typically low during the spring shoulder season, observed year-over-year declines (despite falling natural gas prices) are clearly attributable to further demand contraction associated with the pandemic's onset. While a modest economic recovery and an expected hot summer offer relief to strained merchant cash flows, this summer's results are unlikely to put the sector on a sustainable financial path. Looking beyond 2020, continued growth of the renewable segment will drive continued compression of spark spreads, with payments for resource adequacy growing in importance for merchant gas-fired generation.
S&P Global Platts Analytics believes that while power demand is recovering from the peak of the COVID-19 pandemic, a full return to business as usual is unlikely in 2020, as the economic impact of COVID-19 is compounded by enduring behavioral changes. Meanwhile, in the low demand environment, there have been new levels of turn-down flexibility from previously baseload generation forms such as nuclear and lignite, which has lessened the downside to wholesale power prices. We expect this heightened responsiveness to endure beyond the near term.
As for renewables investments, delays in new construction due to supply/logistics constraints will not have a long-lasting impact. Although renewables account for the majority of the current annual capacity increments and appear resilient given the unprecedented market context, S&P Global Platts Analytics notes that wind and solar growth faces some more structural challenges in the near term, which will require a stronger policy support. This support has so far emerged more clearly in Europe.
Below, representatives from S&P Global Ratings, S&P Platts Analytics, and S&P Global Market Intelligence answer questions related to the latest developments and how and they might affect the creditworthiness of power producers.
In S&P Global Platts Analytics' view, how is COVID-19 affecting the global renewables outlook, which technologies could be more at risk, and which ones could benefit?
S&P Global Platts Analytics projects global renewables (solar and wind) capacity additions of about 162 gigawatts (GW) for 2020, which is 6% lower than our projection in February. However, we believe delays in new construction due to supply/logistics constraints will not have a long-lasting impact. In addition, we expect that global annual renewables capacity additions (wind/solar) for 2021-2025 will stay flat at 2019 levels (about 168 GW/year, on average).
Uncertainties around power demand recovery, fossil fuel prices, and policy support could undermine further growth. In particular, we see risks for grid-parity projects or projects exposed to wholesale power prices. The fluctuations in power prices in recent months show how much volatility merchant projects can face, which could deter further development.
The renewables industry faces some challenges scaling-up globally. Wind and solar accounts for only about 9% of the total power mix globally in 2020. We believe clearer and stronger policy support is necessary for renewables to expand enough to cap any rise in global temperatures by 2 degrees C through 2050. A stronger policy support has been clearly emerging in Europe, and it's interesting that the hydrogen strategy in Germany (and across the EU) is putting an emphasis on renewables power, though it's still not clear how this can translate into higher renewables newbuild.
Although solar is the leading technology for annual installations, COVID-19 has emerged at a fragile time for the global solar PV industry due to major changes in a number of key countries' support mechanisms for such projects. Despite fairly weak tenders activity for wind so far this year, wind projects (offshore ones in particular) will continue to benefit from stronger policy support in the U.S., Europe, and China.
The increasing share of renewables in the power mix--which has come with greater power price volatility and, in some cases, curtailments--has highlighted the need for more flexibility. This means room for battery storage development. As more conventional generating capacity is retired, especially in the U.S. and Europe, we believe more batteries will be needed to boost flexibility and supplement renewables for peaking capacity.
S&P Global Platts Analytics is separate and independent from S&P Global Ratings.
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What is the big reason behind spark spreads decreasing in the Northeast U.S. over the last few years, and what does S&P Global Platt Analytics expect going forward?
Fundamentally, there have been a few key contributing factors to the decline in spark spreads:
Load growth. Grid-level demand for electricity has been declining on a weather-adjusted basis in the Northeast U.S. This is due to weak economic growth, strong energy-efficiency measures, and policy measures incentivizing behind-the-meter generation growth.
Supply stack evolution. Over the past decade, the supply stack in the Northeast U.S. (especially in PJM) has shifted significantly. Inefficient coal-fired generation has retired or converted to gas-fired generation. At the same time, renewable generation capacity and efficient combined cycle gas-fired generation have grown. Tax credits for renewables, decreasing costs of building, environmental concerns, and an increase in natural gas availability at lower prices have fostered this evolution.
Natural gas prices. An abundant supply of natural gas in the U.S. led to lower gas prices and the consequent supply stack shift. The low gas prices also contributed to a decline in the wholesale power prices and reductions in spark spreads. This lack of load growth--combined with policy-driven and/or low-cost, efficient generation--has led to an increase in reserve margins and hence a decrease in implied spark spreads.
We expect the energy market margins (spark spreads) to stay around these levels as weak load growth and stronger renewable portfolio/clean energy standards and other such policy mandates persist. These, along with continued cost reductions in renewables (and storage) and availability of low-cost natural gas, will likely keep the implied spark spreads in check. These and other related forecasts are available via Platts Analytics North America Electricity Service.
S&P Global Platts Analytics is separate and independent from S&P Global Ratings.
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What are S&P Global Ratings' views on the credit quality of independent power producers (IPPS)?
Through the pandemic, we have maintained positive outlooks on four IPPs. We believe the impact of the economic slowdown on IPPs has been relatively muted so far, especially compared to sectors such as oil and gas and refining. Even during such an unprecedented shutdown, it takes time for the energy juggernaut to slow. However, we believe operational diversity and countercyclical retail power operations that provide a hedge against weakness in wholesale power markets can have a significant effect on credit quality.
Given IPPs' focus on reducing leverage in recent years, the ones with a positive outlook have much healthier balance sheets and liquidity. Only Exelon Generation Co. LLC has near-term maturities; some companies' nearest maturity isn't until 2023 or 2024. Moreover, under our base-case scenario, all companies generate free operating cash flow, even after the COVID-19-related sensitivities. Arguably, their cash flow for 2020 will be lower and their financial ratios a trifle weaker than we had estimated. Still, that might not affect these companies' credit profiles because they could simply change their capital allocations to keep reducing leverage.
For an upgrade to 'BB+' from 'BB', we would expect companies such as NRG Energy Inc. and Vistra Energy Corp. to sustain adjusted debt to EBITDA of below 3.0x and adjusted funds from operations to debt of above 25%. We expect to start reviewing the IPPs with positive outlooks for possible upgrades by year-end as the economy recovers.
However, an investment-grade rating would require us to be confident that power markets will remain structurally sound and will not experience any price erosion because of decreasing loads. Based on forward curves and current hedges, there is the possibility of a 10%-15% decline in wholesale EBITDA of IPPs in 2021, before taking into account any hedging and mitigation. However, IPPs have demonstrated their ability to mitigate volatility through hedges, despite a backwardated forward curve. In fact, we believe IPPs in ERCOT are hedging for 2021 because the forward curve is still structurally strong and holding up well. For example, in its first-quarter 2020 earnings call, Vistra indicated that it is about 57% hedged for 2021, noting that nearly 70% of its EBITDA comes from ERCOT.
Nevertheless, we see the ability of IPPs to preserve future cash flow as a material risk if a second wave of coronavirus cases emerges, or if the actual path of the recovery is much slower than anticipated. There are two paths for IPPs to achieve investment-grade ratings:
- They could continue on their leverage-reduction path such that they can sustain adjusted debt to EBITDA at or below 2.5x, which would result in an improvement in the financial risk profile category to intermediate from significant.
- Alternatively, a relatively stable performance through the recession and some visibility on the resilience of the forward power curve could result in a category improvement in their business risk profiles.
What is the outlook for North American utilities' capital spending?
We expect annual capital spending for North American electric, gas, and water regulated utilities to be approximately $150 billion annually for the next two years. We expect that almost all utilities will work constructively with their regulators prior to the implementation of their short- and long-term resource plans. We also expect that resource planning decisions, as determined by the regulator, will reflect the customers' needs, which often factors in environmental concerns and costs.
In terms of the upcoming elections, the industry has a long history of effectively working with both Democratic and Republican administrations. We expect that the industry's annual capital spending of about $150 billion will not drastically change over the medium term, even if there is a new administration in November.
How will COVID-19 affect North American utilities' credit metrics? And how might regulators require utilities to update risk assessments or resource needs in light of COVID?
We expect that the North America regulated utility industry's FFO to debt will weaken by about 100 basis points. We will continue to assess each utility based on their own credit quality and expect that each company will maintain credit measures that are consistently above their downgrade threshold. We expect utilities and regulators will continue to learn from COVID-19. We expect that utilities will continue to assess their operational readiness, employee safety, and service reliability. However, we believe it is still too early to determine how these assessments or other policies might directly affect regulatory proceedings.
Prior to the coronavirus outbreak in North America, about 25% of the utilities had a negative outlook or ratings that were on CreditWatch with negative implications. Because of issues like tax reform, high capital spending, and M&A, credit quality was already weakening prior to COVID-19. Going forward, we believe that all utility stakeholders--including regulators--will be monitoring the potential cash-flow implications of lower sales margins because of weak power demand, and the impact of bad debt expense. This is especially the case for those utilities with commercial and industrial loads that account for a high percentage of their customer base.
With regards NYISO, what does S&P Global Market Intelligence expect the current lower capacity payments to persist over the longer term? Also, will the closure of Indian Point have a material positive benefit for the remaining gas plants?
It appears that the impact of Indian Point phase-out is priced in already, and so we expect no further uplift. Further support to capacity markets will depend on net impact of New York City storage procurement versus the retirement of legacy peakers. Overall, summer capacity premiums are likely to erode absent changes to the auction process.
S&P Global Market Intelligence is separate and independent from S&P Global Ratings.
What does S&P Global Market Intelligence expect in terms of the overall impact to the generation stack with the replacement of higher-capacity factor generation by lower-capacity factor and intermittent renewable generation? In other words, what multiple of capacity is needed when displacing traditional generation by renewables?
Renewable generation is becoming more cost efficient as a source of on-peak reliability, notwithstanding intermittency. This is due in part to higher capacity factors from new onshore wind and the expansion of offshore wind, as well as the use of storage to shift solar generation into the market at peak times. Nevertheless, in installed capacity terms, legacy fossil generation capable of running most hours of the year will take more green energy to replace it. Given a regional mix of two-thirds wind and one-third solar, we expect 1.75 MW-2.00 MW of green capacity will be needed for every 1 MW of conventional retired. But the emerging battery storage segment will likely move this multiple down a bit.
S&P Global Market Intelligence is separate and independent from S&P Global Ratings.
What trends does S&P Global Market Intelligence see in peaking gas generation in the Northeast U.S.?
Peakers will face growing competition from renewables storage, which will erode the investment value of peakers over time.
S&P Global Market Intelligence is separate and independent from S&P Global Ratings.
In S&P Global Platts Analytics' view, in Europe how will the replacement of higher-capacity factor generation by lower-capacity factor and intermittent renewable generation affect the generation stack?
On a straight load-factor basis, typical annualized run rates approximate 10%-15% for solar PV and 25%-50% for wind (the former being more typical on onshore generation and the latter regularly achieved or exceeded for offshore wind in U.K. waters). On that basis alone, 7GW-10GW of solar or 2GW-4GW of wind is equivalent to 1GW of nuclear, which typically runs at maximum load factors when online. But clearly there is considerable variability to these levels--both on a very short-term and even seasonally. That means power stacks need to be able to cope with still, dark conditions and consequent low wind/solar output.
What that has meant in Europe is the overall size of capacity increases and new investment in flexibility have been focused (from the generation perspective) on small-scale, low-capex, high-opex thermal plants such as open-cycle gas turbines and reciprocating engines. These are attractive because they can earn their (relatively low) investment costs back over a short timeframe by capturing value at the top of the stack at times of super-peak prices. They could also benefit from grid service payments due to their ability to respond quickly.
Demand-side response programs and battery storage are also targets of investment. The former could come through behind-the-meter generation at industrial facilities. In the case of the latter, batteries are earning increasing revenue from balancing and wholesale markets, in part reflecting increased sophistication around aggregation of capacity by specialist third-party agents and changing market rules to facilitate their participation in short-term markets. However, grid service revenue--most notably, frequency response services--is still a major revenue stream for small-scale storage. Interconnectors also should not be discounted as a form of flexibility; the European Union has targets in place for the portion of demand that a member state must be able to match through interconnection, and funds are available for new projects.
Investment in large-scale generation plants of any kind is now dependent on some form of guaranteed revenue stream or nonmarket support. A significant factor in this is the growing level of subsidized renewable generation on the networks and the long-term uncertainty around technology cost development, making 15-year investment decisions highly risky. Individual EU countries have dealt with this by plugging the gap through capacity markets.
For example the U.K. capacity market offers 15-year contracts to new build projects with a £/kW payment made on the basis that contracted capacity is available if called on in a supply emergency. However, even in this market, most of the successful new build capacity has been small-scale peak plants. Only one large-scale CCGT is under construction in the U.K., and this project benefits from various favorable terms and is unique. Investment decisions in large-scale projects elsewhere in Europe--whether nuclear or gas--are also thin on the ground. However, last year Italy last year commissioned some new capacity from a combination of new building and coal conversion projects via capacity market auctions.
S&P Global Platts Analytics is separate and independent from S&P Global Ratings.
Post COVID-19, will the European energy transition target remain, and will European utilities benefit from it?
With relatively solid balance sheets and already strong positions in renewables and networks, we see European utilities as well positioned to benefit from the strong push into green infrastructure, providing a defensive and sustainable growth pattern. In fact, we have not seen any material negative adjustments in infrastructure investments for the next three years on the sector as a response to the COVID-19 situation. Indeed, we see sustained high investment levels remaining over the coming three years to accompany the energy transition.
European policies on energy transition accelerated with the agreement on the European Green Deal in December 2019. This plan emphasizes the path toward a net zero economy by 2050, providing greater visibility on future power generation technology mix and eventually unlocking capital for investments in green infrastructure. This Green Deal plan now takes another turn with COVID-19 by being identified as a pillar of the European economic recovery. At the same time, we recognize that the Green Deal and other national stimulus packages for infrastructure will not only take time to materialize (not expected to take place before 2021) and will be spread over the decade. This is therefore not a short-term boost.
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The COVID-19 crisis also highlighted European utilities' significantly decreased exposure to merchant power activities and the relative defensive business profile they have built in recent years. This is supported by material disposals of conventional thermal generation, repositioning in networks and significant growth in long-term contracted renewables. In this context, most of the sector will be able to cope with the currently weaker power price environment and lower power demand. We expect this sector trend toward lower exposure to volatile merchant power market will continue in the coming three years.
Related Research
- Despite COVID-19 Disruption, European Utilities Are Set For Growth, June 25, 2020
- The Energy Transition And What It Means For European Power Prices And Producers: Midyear 2020 Update, June 8, 2020
- U.S. Energy Update: Refining Our Views On Independent Power Producers, June 8, 2020
- Unregulated Power Update: Independent Power Producers Navigate Falling Demand And Credit Risks In Wake Of Economic Shock, May 6, 2020
- COVID-19: The Outlook For North American Regulated Utilities Turns Negative, April 2, 2020
- North American Regulated Utilities Face Additional Risks Amid Coronavirus Outbreak, March 19, 2020
- Energy Transition: Renewable Energy Matures With Blossoming Complexity, Nov. 8, 2019
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S&P Global Ratings, S&P Global Platts Analytics, and S&P Global Market Intelligence are separate, independent divisions of S&P Global.
This report does not constitute a rating action.
Primary Credit Analysts: | Trevor J D'Olier-Lees, New York (1) 212-438-7985; trevor.dolier-lees@spglobal.com |
Massimo Schiavo, Paris + 33 14 420 6718; Massimo.Schiavo@spglobal.com | |
Pierre Georges, Paris (33) 1-4420-6735; pierre.georges@spglobal.com | |
Aneesh Prabhu, CFA, FRM, New York (1) 212-438-1285; aneesh.prabhu@spglobal.com | |
Obioma Ugboaja, New York + 1 (212) 438 7406; obioma.ugboaja@spglobal.com | |
Secondary Contact: | Emeline Vinot, Paris (33) 1-4075-2569; emeline.vinot@spglobal.com |
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