European utilities' credit quality has been resilient to the economic fallout from the COVID-19 pandemic. Since early March, we have taken only a limited number of negative rating actions on our rated portfolio (see table 1). Our COVID-19-related rating actions include downgrades on Engie, TVO, and EDF, which were each lowered by one notch. Their relatively higher exposure to merchant activities and weak credit metrics for their respective ratings before the pandemic were the main reasons for the downgrades. Currently, 21% of utilities we rate carry a negative outlook or a CreditWatch with negative implications (see chart 1). This compares with 37% for all European ratings as a whole negatively affected by the crisis and reflects the sector's resilience to the COVID-19-related economic disruption.

Chart 1

Table 1

This resilience is underpinned by the regulated nature of the network activities, generally governed by supportive regulatory frameworks that make operators immune to volume or price risks. It is further strengthened by the long-term contracted nature of their renewables generation activities, which also provide a good hedge to power-price volatility. Since 2016, European utilities have drastically transformed their portfolios to increase the relative share of these two defensive core businesses, while at the same time disposing some of their merchant activities. At year-end 2019, the average share of EBITDA from networks and renewables was 66% for the top 14 utilities (see chart 2).

Chart 2

Pure network operators are obviously even more protected in the current environment, and we have not taken any COVID-19-related rating actions on these players. Rating pressure stems rather from ongoing regulatory resets across the continent, which generally aim to reduce regulated revenues to better reflect companies' lower cost of capital and operating performance. That said, we acknowledge that there may be some delay in revenue recognition due to lower demand and volumes in 2020. We nevertheless anticipate that any such mismatch will be recovered within the next two years, and this is anchored in the respective regulations.

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.

Power And Gas Generation Will Suffer

We expect some weakening in earnings for power generators given that power prices are hit by low commodity prices and weak demand (see "The Energy Transition And What It Means For European Power Prices And Producers: Midyear 2020 Update," published June 8, 2020, on RatingsDirect). Yet, apart from a few specific cases, such as EDF or Statkraft, we do not foresee a major financial impact in 2020 because power price hedges are generally high. Performance will likely weaken in 2021, however, because hedges are still only partial (30% to 70% of production, depending on companies and markets) and forward prices point to lower levels. The situation in the Nordics remains the toughest for power prices: the COVID-19 crisis has exacerbated downward pressure stemming from unfavorable weather conditions since the beginning of the year, owing to high hydro levels and a mild winter. We expect these weak conditions will continue next year.

Table 2

On the supply side, we see two main risks:

The significant drop in demand during the lockdown period and the likelihood of lower demand for the rest of the year.   This will force suppliers to sell their surplus hedged positions at a loss this year. We continue to anticipate an annualized drop in demand of about 7% on average in Europe, with greater falls in most affected countries (Italy and the U.K.) and lower ones in Germany and the Nordics.

Bill collection delays and rising bad debt.   Regulators and governments have advocated payment holidays, and some suppliers have offered them voluntarily to some of their weaker customers. This is leading to a spike in working capital. We expect this to be manageable for all utilities that we rate given the relatively short timeframe of payment holidays, the limited number of eligible customers, and utilities' relatively high liquidity cushion. Yet, we anticipate default rates will increase materially once government support mechanisms start to disappear after the crisis. We may then see an increase of bad debt. At present, we understand most suppliers have not increased their provisions for bad debt materially. This is because suppliers anticipate that defaults are more likely to materialize in 2021 given liquidity buffers provided by the various governments, and because they expect to rapidly cut power to bad payers to limit losses. Suppliers most exposed, in our view, are those with large B2B activities, notably in services and small businesses. All in, we anticipate that amounts at risk could be material, possibly in the low €100 million range for the largest suppliers. However, this should be manageable in most cases, given the relatively low contribution to consolidated EBITDA.

Lower demand and a prolonged economic slowdown will also hurt energy services, which we view as more cyclical in nature. Industrials and public municipalities will likely reduce discretionary non-priority spending. Engie's earnings in 2020 will be hit, owing to its asset-light client solutions business (EBITDA down 6%-7% for the group) and we expect only a gradual recovery of asset-light services over 2021-2022. Centrica could also experience similar negative pressure.

Network Operators' Investments Remain Intact

Power network operators in Europe are continuing to invest heavily in the energy transition, particularly as support grows for a green recovery from the COVID-19 economic crisis. Investments include:

• Continued upgrades of existing, but old asset bases, including digitalization and automation;
• Connections to new renewable power plants, such as wind farms and solar fields; and
• Provision for more decentralized energy systems, such as rooftop solar photovoltaic (PV) systems, and for new demand such as data centers, clean heating, and charging stations for electric vehicles.

Overall, we estimate investments by our rated network operators will average €30 billion per year over 2020-2022, compared to an aggregate level of about €25 billion over 2017-2019 (see chart 3). We therefore do not believe that the COVID-19 crisis has materially affected European networks' investment levels.

Chart 3

Chart 4

As a result of these investments, we expect most power operators will expand their regulatory asset bases, which should, in turn, help mitigate earnings' downside stemming from regulatory resets across the continent. Many regulators are resetting regulated power prices to better reflect the utilities' lower cost of capital due to cheaper financing and operating performance, after revenues in recent years overperformed significantly. Our current ratings and outlooks already factor in this earnings' downside risk and we do not believe the COVID-19 crisis will add further material negative pressure.

We do not envisage any significant acceleration in investments in networks beyond current levels over the coming years, despite good momentum for new infrastructure spending. This is notably because more spending will mean higher energy bills for end-consumers, which we believe will be more difficult to accept in a subdued economic environment. We also recognize that network operators will find it very difficult to balance high investments with generally lower regulated revenues following regulatory resets across the continent, while also sustaining credit quality. Nevertheless, our recent rating actions in the sector have largely taken into account these challenges over the next two to three years.

For gas networks, we see relatively weaker growth prospects given that the net zero carbon emission target by 2050 set by the European Commission (EC) implies a smaller role for gas in the energy mix over time. Still, we do not envisage any change in our pre-crisis expectations: gas will remain strategically important for Europe to ensure an effective energy transition over the coming decade, but new investments and expansions will be subdued compared to the past decade. The EC's newly proposed €1 billion budget allocation for hydrogen research and projects could accelerate a new, greener use of the gas infrastructure. However, we believe this remains a long-term and uncertain prospect for now.

Renewables Have Strong Growth Prospects

Unlike the International Energy Agency (IEA), which forecasts a material drop in global renewables investments for 2020 and partial recovery in 2021, we do not expect a material change in the investment pipeline of European utilities we rate. We base this view on several factors:

• Large utility projects are less affected by the pandemic than smaller, individual projects such as rooftop solar PVs. The latter will likely be affected by individuals' more limited purchasing power and supply chain disruption because most solar PV panels come from China, where plants had to shut down temporarily at the beginning of the year due to the pandemic.
• We have not seen any major construction delays or supply chain disruption among the largest renewables players that we rate. Wind turbine suppliers and other contractors were able to continue operating during the lockdown. We have heard anecdotally of delays of a few weeks, but we understand these will likely be absorbed during the course of the projects. We have also not heard of any major capex cuts or reduced ambitions on investment pipelines. Iberdrola, Enel, EDP, ENGIE, and Orsted, for example, have all confirmed their goals to bring new renewable capacity on line over next two years.
• We believe merchant renewables projects have also been affected by reduced risk appetite from financiers as a result of COVID-19 disruption. Still, we understand that this is not affecting the large players given the largely contracted revenue stream of their projects and their better access to capital markets.
• For players with large exposure to the U.S., the continuation of the "tax equity interest" fiscal incentive scheme post 2020 offers additional growth prospects beyond this year.
• European environmental targets continue to offer supportive growth momentum for renewables. We do not expect that the low commodity prices, and therefore cheaper gas and coal production, will affect Europe's path toward greener energy.

We also expect growth in renewables may come from acquisitions of existing portfolios and pipelines. This is because European utilities have balance-sheet flexibility to acquire midsize entities and finance the construction phase of these pipelines to consolidate their market positions and geographic reach.

European oil majors accelerating into the energy transition, in particular into the renewables space, are likely to present competitive challenge to utilities. Recent strategic updates by Shell and Total point to net zero carbon targets by 2050, while BP will unveil its greening plans in the fourth quarter of this year. These players have excellent engineering capabilities, significant investment capacity, and lower cost of capital, which should help them maneuver into strong positions in the renewables space in the coming years, hence becoming credible competitors to European utilities. We therefore see a need for utilities to adapt to these market dynamics to remain competitive and continue to yield returns.

Political Green Deal Support Will Provide Benefits In The Long Term

Before the COVID-19 disruption, Europe presented its Green Deal, strengthening its willingness to accelerate its path to decarbonization by mobilizing resources to reach a target of net zero carbon emissions. We think this pre-crisis roadmap will now serve as a key enabler of the European recovery, or at least as an investment direction for benefiting from a European stimulus package. Overall, we believe the Green Deal benefits the European energy sector by supporting investments in renewables and networks to accelerate decarbonization. It is also shaping national energy markets, providing enhanced visibility on energy mix targets, which is positive for European utilities.

We nevertheless expect that this program will be spread over the coming decade rather than a front-loaded stimulus package. We also see a misalignment between the ambitious European targets and the reality on the ground, where administrative hurdles and local opposition remain key constraints both for network extensions and renewable projects. As a result, while we believe the Green Deal could accelerate investments in renewables over time, we remain cautious about any significant short-term upside.

We also see permit constraints as a major hurdle for development of renewables in Europe. Given that authorities are ploughing resources into managing the pandemic, we expect less progress to be made in simplifying administrative work to unlock renewable projects.

Excellent Capital Market Access For Developed Market Players

We expect European utilities will continue to benefit from favorable financing conditions in the coming quarters given the continued low borrowing rates in Europe, utilities' high credit ratings, and their perceived defensive profiles. The sector has issued significant amounts of bonds since early March, which has continued to contribute to lowering their average cost of debt. We therefore do not expect funding conditions in the COVID-19 crisis will constrain their investment appetite.

We are also seeing continued investor interest in infrastructure, which is supporting already high valuations and may allow for monetization of more mature, non-core assets. We believe such asset rotation remains an important option for some utilities to maintain a balance between their credit standing and their investment pipeline.

The situation is less rosy for utilities in emerging markets, for which COVID-19 has added to other company-specific pressures. For instance, we placed the Croatian utility Zagrebacki on CreditWatch with negative implications due to the earthquake in March. However, the disruption from COVID-19 made it more difficult for the city of Zagreb to provide timely support and for the company to access financing to physically repair its asset base while its employees were in a lockdown situation. Similarly, we placed the Georgian Oil and Gas Corporation on CreditWatch negative due to refinancing risk, but COVID-19 disruption made it more difficult for the company to access capital markets for timely refinancing of its Eurobond maturing in 2021. The Ukrainian renewables operator DTEK, has also been indirectly negatively affected by the COVID-19 crisis, in our view. The government-related offtaker is in arrears for renewable energy, and now the government has approved renewable tariff cuts and ordered a stop on power purchase agreements for renewable construction in exchange for starting to pay for renewable electricity. In our view, COVID-19 and a related decline in commodity prices were among the main reasons that made high renewable tariffs unaffordable, and affected customers' and offtakers' ability to pay.

Related Research

• COVID-19: What Would A New Tariff Deficit Mean For Spain's Electricity System Operators? June 25, 2020
• French Utility EDF Downgraded To 'BBB+' On Prolonged Operational Weakness, Lower Output Due To COVID-19; Outlook Stable, June 22, 2020ENGIE SA Rating Lowered To 'BBB+' On Less-Resilient Business Amid Looming Recession; Outlook Stable, April 24, 2020
• The Energy Transition And What It Means For European Power Prices And Producers: Midyear 2020 Update, June 8, 2020
• WEBCAST REPLAY: Power Markets Outlook And Credit Implications In The Age Of COVID-19, June 10, 2020