Our ratings on the investor-owned North America regulated utilities began 2021 the same way that it ended 2020--with downgrades. The early 2021 downgrades of Atmos Energy Corp. (A-/Watch Neg/A-2), Duke Energy Corp. (BBB/Stable/A-2), One Gas Inc. (BBB+/Negative/A-2), and National Grid North America Inc. (BBB+/Stable/A-2) reflect our view of the minimal financial cushion at their current rating level prior to the downgrades. This is consistent with the more general industry trend of higher leverage driven by robust capital spending necessary to reduce greenhouse gas emissions, enhance reliability, and improve safety.

Last year was the first year in a decade that our downgrades outpaced upgrades in this sector and at this early 2021 juncture, it appears that for the second consecutive year, downgrades will again outpace upgrades. Additionally, while our median rating for the industry remains at 'A-', the cushion has significantly shrunken and the median rating is moving ever so close, for first time ever, to the 'BBB' category.

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Relying On Only Minimal Financial Cushion

Since we revised our industry outlook to negative at the beginning of 2020 (COVID-19: The Outlook For North American Regulated Utilities Turns Negative, April 2, 2020) we have consistently highlighted the lack of financial cushion (see chart). While utility cash flows are generally more predictable than most other industries and therefore utilities can typically manage them closer to their ratings downgrade threshold, unexpected events that arise beyond the base case, can often result in a weakening of credit quality.

In our view, Atmos Energy, Duke Energy, One Gas, and National Grid were generally operating with minimal cushion, prior to their downgrades. Our rating actions on OGE Energy Corp. stands in contrast to these entities. We affirmed the ratings on OGE Energy Corp. and only revised the outlook to negative, despite the company also being negatively affected by the Texas storm, experiencing $800 million to $1 billion of higher fuel and purchased power costs. The primary reason for the ratings affirmation, despite the high costs, reflects our view of sufficient financial cushion prior to the unexpected winter freeze.

ESG Risks

S&P Global Ratings has consistently highlighted the many ESG risks that could potentially harm the industry's credit quality (Webinar Spotlights The North American Regulated Utility Sector's Key Trends And Risks, Feb. 2, 2021). Some of the potential ESG-related risks include:

• Climate-related risks including wildfires, storms, hurricanes, and extraordinary hot or cold temperatures.
• Regulatory risks. Rising costs and higher capital spending could pressure the industry's regulatory support and expectations of full recovery of such costs from ratepayers.
• Consistent access to the capital markets at a fair price. To the extent that investors are taking environmental concerns into consideration, utilities with higher carbon emissions might not have the same capital market access or pricing as peers, potentially weakening credit quality.
• Stranded asset risk. Should regulators and customers no longer support fossil fuel-based assets and instead determine that full electrification and renewable generation should replace the industry's natural gas distribution system and natural gas-fired generation, these assets could become stranded assets, potentially weakening a utility's financial measures and management of regulatory risk.

Recent examples underscore the risks

Duke Energy Corp.'s credit quality took a hit when it agreed to a settlement, failing to fully recover its coal ash costs (Duke Energy Corp. And Subsidiaries Downgraded To 'BBB+' On Coal Ash Settlement, Outlook Stable, Jan. 26, 2021). The devastating winter storm in February that plunged much of Texas into a deep freeze and knocked out power to millions of homes sharply increased local natural gas spot prices by more than 35,000% during the week of frigid temperatures around the region. During this timeframe, local natural gas prices increased to more than $1,000 per MMBtu from about $3 per MMBtu. As a result of this drastic increase, we downgraded both Atmos Energy Corp. (Atmos Energy Corp. Downgraded To 'A-' On Weakening Credit Metrics; Ratings Placed On CreditWatch Negative, Feb. 22, 2021) and One Gas Inc. (ONE Gas Inc. Downgraded To 'BBB+' From 'A' On Unprecedented Weather Conditions; Outlook Negative, Feb. 23, 2021), reflecting weaker financial measures from the added leverage necessary to fund the exorbitantly priced natural gas.

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Another once in a century event

While some could dismiss the Texas storm as a "once in a century" event, over the past several years we have seen many of these rare and unpredictable events. This includes the polar vortex, the global pandemic, catastrophic wildfires, severe storms, and the recent winter freeze. Our view that these events have affected the credit quality of some of the industry's utilities, demonstrates the need for the industry to proactively reduce its ESG-related risks.

Hindsight

When looking back and assessing the recent winter freeze's negative impact on the natural gas distribution companies' credit quality, we believe a comprehensive hedging program could have limited the billions in higher fuel costs. While we view a utility's ability to fully recover its fuel and purchase power costs from ratepayers as an important credit-supportive component, in this instance, this traditional tool by itself was insufficient.

The Texas storm's unprecedented climate related risks highlights the need for additional credit-supportive measures to maintain credit quality. Because of the spike in natural gas prices, the costs that had to be recovered from ratepayers were simply too burdensome to be recovered through traditional means. Had a utility even attempted to pass these costs onto its ratepayers, it would have overwhelmed the customer bill, probably leading to customer outrage. In fact, a non-rated, retail energy provider attempted to bill customers for these higher costs and it immediately faced enormous public pressure. In hindsight, a comprehensive hedging program that includes both physical and financial hedges could have significantly lowered these higher costs, reducing credit risk.

Looking forward, given the more frequent risks of climate change, a comprehensive physical and financial hedging program could be an additional tool that if more frequently implemented, could potentially reduce the industry's credit risks. Such a program, if implemented properly, has the potential to significantly reduce risk when a utility is facing an unexpected commodity price spike.

Expecting More Of The Unexpected

The industry's credit quality is off to a challenging start, partially reflecting the increasing ESG risks that if not addressed could continue to erode credit quality. What's more, regulated utility companies are not well positioned to handle unexpected events because so many of them operate with minimal financial cushion at their particular rating level. Despite these risks, we expect that a higher corporate tax rate could offset some of this exposure, resulting in a modest improvement in credit quality (U.S. Regulated Utilities' Credit Metrics Could Strengthen Under Proposed Biden Tax Plan, Oct. 29, 2020). However, if Congress delays the passing of a higher corporate tax rate, given the increased frequency of ESG risks, we could lower the industry's median rating to the 'BBB' category well before year-end.

Related Research

• OGE Energy Corp. And Sub. OG&E Outlooks Revised To Negative On Unprecedented Winter Related Costs; Ratings Affirmed, March 3, 2021
• National Grid North America Inc. Downgraded To 'BBB+' Following Downgrade Of Parent, March 3, 2021
• S&P Global Roundtable: North American Regulated Utilities--Jan. 29, 2021, Feb. 2, 2021
• North American Regulated Utilities’ Negative Outlook Could See Modest Improvement, Jan. 20, 2021
• Industry Top Trends 2021 North America Regulated Utilities, Dec. 10, 2020