Resilience plays an important role in the credit quality of public power and electric cooperative utilities. Strong financial and operational resilience can buttress the ratings S&P Global Ratings assigns to these utilities.

Across the U.S., hurricanes, wildfires, heat waves, and polar vortices have demonstrated the criticality of financial and operational resilience in the face of natural forces attributable to climate change. In response to climate changes, electric utilities are pursuing decarbonization initiatives both independently and to comply with evolving regulations and goals. These initiatives task management with maintaining operational reliability, sound financial performance, and affordability.

In furtherance of decarbonization goals, many public power and electric cooperative utilities have announced plans to eliminate or offset their carbon emissions by 2050 or sooner. However, in recent months, the federal government has floated proposals calling for utilities to accelerate their decarbonization efforts to eliminate by 2035 carbon attributable to electricity production. These goals cite the need to remove the power plant emissions that are the catalysts for climate change and natural disasters. This report explores factors we believe electric utilities will encounter as they pursue reductions in their greenhouse gas emissions.

Although implementation timelines vary from utility to utility, we view utilities' decarbonization plans as tools for moderating the adverse environmental effects of electricity production. We associate positive governance characteristics with utilities that proactively plan to reduce greenhouse gas emissions to benefit the environment and the well-being of people and businesses within the shadow of utilities' power plants. Although exposures to health and safety risks could improve with decarbonization, the cost of decarbonizing could lead to higher retail electric rates and affordability issues, which could exacerbate social risks. Costs that reduce rate affordability and ratemaking flexibility might negatively affect credit ratings.

Although many public power and electric cooperative utilities are working to reduce reliance on carbon-based fuels, it remains unclear whether available technologies and their economics will support achievement of clean energy goals when targeting 2035. So far, the costs and operational effects of decarbonization initiatives have largely dovetailed with reliable utility operations, affordability, and sound financial performance, in part because the declining costs of renewable technologies have helped mitigate the cost pressures associated with the transition from carbon-based fuels. Going forward, the success of efforts to develop new and economical storage technologies that can counter the intermittency of renewable resources will be important to decarbonization. Ultimately, legislative and regulatory deadlines for decarbonization, their alignment with available technologies, and their affordability, will influence the financial and operational costs of transitioning from carbon-based resources--and the credit ratings we assign. As utilities reduce carbon emissions, we believe they will face the costs associated with premature retirements of existing conventional resources along with the costs of adding new, cleaner assets.

The U.S. Electric Sector Reports Progress, But Much Work Remains

Carbon emissions from electric generation declined during the past decade as utilities sharply reduced coal production and added renewable resources (see charts 1–3). These reductions reflect both active and passive decisions by utility management.

While active decisions almost universally underlie commitments to renewable resources, the same is not the case for coal generation retirements. Many coal power plant retirements were by design, but circumstances drove other retirements because a decade of low natural gas prices have whittled coal's historical economic dominance (chart 4). Natural gas prices have spiked in recent months, which has eroded some of natural gas' competitive advantage over coal, but natural gas futures suggest that prices will moderate in 2022.

Against the backdrop of the past decade's significant carbon emissions reductions, coal and natural gas still account for 60% of U.S. electricity production, suggesting that electric utilities have their work cut out for them if they are to decarbonize on an accelerated schedule.

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A Focus On The Affordability Of The Clean Energy Transition

The allure of replacing existing generation with clean energy from wind, solar, and other environmentally friendly resources, tasks utilities with maintaining reliable operations, affordability and financial performance that preserves credit quality.

As utilities wean themselves from carbon-based fuels, S&P Global Ratings' analyses explore whether transitional costs will affect affordability and ratings.

When assigning ratings to public power and electric cooperative utilities, S&P Global Ratings assesses many qualitative and quantitative factors, including retail rate affordability. We view affordability as important to financial flexibility because affordability is an indicator of the capacity to adjust retail rates in response to rising operating costs. Having the flexibility to raise retail rates facilitates financial resilience and sound ratings. Therefore, as utilities proceed along the energy transition path, we are examining whether they can maintain affordability and reliability while recovering investments in the existing generation they are retiring prematurely and in the new generation they are financing.

The Challenge Of Intermittency

Operational considerations add to the challenges of transitioning to cleaner generation.

Aligning the variable output of renewable resources with consumers' expectations for around-the-clock access to reliable and affordable electricity is another piece of the strategic puzzle utility management faces (chart 5).

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In August 2020, California's electric grid illustrated stumbling blocks that utilities elsewhere might encounter as their mix of dispatchable and intermittent resources evolves.

During that summer's heatwave, California's grid operator instituted rolling blackouts over two days that affected hundreds of thousands of customers. The California Independent System Operator (Cal ISO), which oversees the bulk electricity system and market, needed to shed load because of supply shortages during solar panels' dormant hours.

In recent years, at the same time that renewable resource additions were flourishing in California, utilities and merchant generators were retiring gas-fired resources to reduce their carbon footprints (chart 6). The convergence of intermittent resource additions and the retirement of dispatchable resources played a significant role as catalysts for the supply shortages and blackouts. But there were other drivers, including constraints on the amount of electricity California was able to import due to the regional breadth of the heat wave. Once again, this past summer, the Cal ISO urged residents to conserve energy to compensate for grid limitations. Plans for the California grid to shed more than 2 gigawatts of nuclear generation in 2025 when PG&E Corp. will retire the Diablo Canyon nuclear plant might aggravate the grid's susceptibility to load shedding.

In California, peak production at solar and wind facilities does not coincide with consumers' peak electricity consumption. An abundance of solar production during the midday hours yields energy surpluses, but during the late afternoon and evening when the grid experiences peak electricity demand, there is a dearth of solar production. Therefore, in California and elsewhere, the intermittency of renewable generation creates a need for significant storage capabilities that can shift surplus energy production to hours with generation deficiencies. We believe that customer ire in the wake of power outages can be a barrier to passing along higher costs to consumers.

The number of U.S. battery storage installations continues to grow, particularly as states mandate storage investments. In 2020, battery storage climbed to 1,650 MW, representing a 35% increase over 2019. Yet, batteries still provide only a modest percentage of firming needs (chart 7). Plans for more clean but intermittent resources could exacerbate this mismatch.

Therefore, at S&P Global Ratings we are watching how the utility industry tackles the operational and financial aspects of mitigating intermittency.

PJM Interconnection has modeled scenarios assessing the effective load carry capability of renewable resources and concluded that avoiding load shedding under some scenarios might require an installed reserve margin of up to 70%.

We believe that beneficial electrification initiatives calling for the electrification of homes, businesses, and vehicles will likely add to pressure on the grid and the need for reliability.

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Mitigating Intermittency Will Add To Cost Pressures

The storage discussion brings us back to rate affordability and the related financial flexibility that is fundamental to S&P Global Ratings' public power and electric cooperative ratings. Some utilities plan to retain portions of their existing conventional generation resources to mitigate intermittency and thereby avoid additional investment expenditures. Some utilities are investing in gas-fired, quick-start units to counter intermittency and others are investing in battery storage. Investments in new backstop resources will likely add to the costs of transitioning to intermittent renewable resources. Investments in new gas-fired facilities also raise the question of cost recovery if environmental mandates truncate the lives of these units.

The cost of lithium-ion battery installations continues to decline. However, the National Renewable Energy Laboratory projects that even with further declines, the per kilowatt-hour (kWh) costs of electricity sourced from lithium-ion battery storage will still be measured in hundreds of dollars per kWh for years to come when considering the recovery of capital costs (chart 8).

Stored energy's cost projections at hundreds of dollars per kWh greatly eclipse the cost of electricity from conventional resources which are measured in cents per kWh. We expect that blending costly batteries with more economical renewable resources can help dilute but not offset batteries' high costs.

Inflationary pressures on key components of existing battery technology could add to the storage hurdles (chart 9)

As electric utilities compete with electric vehicle manufacturers for finite battery resources, they could add to the inflationary pressures along the path to eliminating power sector carbon emissions. Just the same, inflationary cost pressures on battery components might be the catalyst for innovation and developing alternative storage technologies, such as flow batteries.

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The Costs Inherent In Renewable Resources' Sizable Footprint

Renewable resources require far more land per megawatt of production capacity than do conventional resources, which could add another stumbling block along the road to decarbonization (chart 10). We believe amassing substantial tracts of land to cobble together solar panels or windmills will be costly, which can also influence rate affordability and ratings. We believe electric utilities will face these costs irrespective of whether they directly invest in wind and solar projects or enter into power purchase agreements with developers.

Assembling contiguous parcels might also introduce costly eminent domain considerations. The task might become that much more difficult and costly if numerous utilities and developers vie for finite open spaces suitable for hosting renewable generation and storage resources.

Also consider that open tracts of land are rarely proximate to retail electric loads, which will likely necessitate costly transmission investments that are accompanied by frequently contentious right-of-way acquisitions. Congress' Infrastructure Investments and Jobs Act could help reduce barriers to transmission projects through the designation of "National Interest Electric Corridors." In addition, the legislation contemplates enhancing coordination among regional transmission operators to achieve greater interregional electricity transfer capacity .

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A Work In Progress

Most public power and electric cooperative utilities are developing strategies for aligning their electric production and procurement activities with the national aspirations to address climate change to reduce climate events. This report highlights that the transition is a work in progress and many questions remain as industry and public officials face a variety of challenges as they work to provide consumers with clean, affordable, and reliable electric service.

We believe utilities' carbon reduction efforts thus far have been consistent with the affordability and reliability considerations that are integral elements among the many factors underlying the largely stable ratings S&P Global Ratings has assigned within the public power and electric cooperative sectors. We will continue to monitor regulatory and legislative directives, along with utility responses to assess whether the financial and operational effects of decarbonization reach a credit quality tipping point.