Utilities Facing Operating And Financial Challenges Remain Vulnerable To Ratings Downgrades

Although we expect rating stability among most of the sector's electric utilities in 2022, there are pockets of utilities that face heightened risks and whose ratings we could lower. Vulnerable utilities include those facing the operational and financial exposures related to climate change and exposures we associate with participating in the Electric Reliability Council of Texas (ERCOT) market. Within the ERCOT region, regulators, legislators, and utility management teams are working to mitigate the market's financial and operational exposures that February's winter storm accentuated. In December, ERCOT reported that generation owners have completed significant winterization improvements. Yet, we believe that some of the root causes of the extreme financial dislocations many utilities faced during the storm remain.

There are additional groups of utilities that we view as potentially vulnerable to ratings downgrades in 2022. They include wholesale utilities that face member discord that could lead to departures and create revenue stream dislocations, and the handful of Southeastern public power and electric cooperative utilities that are exposed to the extensive and recurring construction delays and cost overruns of the Vogtle nuclear construction project.

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Questions That Matter

1. Will COVID-19 variants affect credit quality among public power and electric cooperative utilities in 2022?

We expect that the ongoing pandemic and its new variants will not be a meaningful driver of negative rating actions in 2022. We expect the revenue streams and ratings of public power and electric cooperative utilities to remain sound in the face of the pandemic, as they did during the pandemic's first two years.

What we think and why

The essentiality of electricity to Americans' personal lives and businesses was borne out during the pandemic.  In 2020, the most recent year for which full-year data is available, electric sales declined modestly by 2.5% compared with 2019. The significance of this small decline is amplified when viewed against the backdrop of 2020's sizable and economically disruptive pandemic-related health and safety measures that suspended business activities. We also believe the contraction of electricity sales in 2020 was not meaningful to ratings because it was consistent with recent years' trends of moderately variable annual electric sales. Year-to-year variability reflects economic factors, weather patterns, and the increasing introduction of beneficial electrification and electric efficiencies in homes and businesses.

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Although S&P Global Ratings views the omicron variant as a stark reminder that the COVID-19 pandemic is far from over, we expect that the essentiality of electric service will continue to limit the variability of annual electric sales volumes and contribute to stable credit ratings among public power and electric cooperative utilities in 2022, as it has since the onset of the pandemic.

The pandemic has had only a limited effect on public power and electric cooperative ratings.  In 2021, the pandemic had a negligible effect on ratings. Rather, the leading driver of the modest number of ratings downgrades among public power and electric cooperative utilities was February's winter storm that saddled utilities in Texas with exceptionally high and unbudgeted fuel and power procurement expenses. We lowered the ratings on 14 not-for-profit utilities to reflect the storm's financial and operational effects. By comparison, we cited COVID-19 as the driver of only one rating downgrade in 2021. We based the rating action on weaker electricity sales and financial performance attributable to COVID-19.

While many utilities have observed upticks in delinquent accounts during the pandemic due to moratoriums on service disconnections and the financial pressures customers faced because of business suspensions and the ephemeral spike in unemployment rates, we expect that utilities will respond by accessing internal and external liquidity and by creating payment plans for delinquent customers. Despite higher delinquencies, reserves for uncollectible accounts remain moderate.

Utilities' generally sound financial performance since the pandemic's inception, the limited erosion of energy sales, and the capacity to respond to delinquencies, display the resilience of the sector's ratings to the pandemic's economic dislocations. Based on the pandemic's small effect on public power and electric cooperative utility ratings in 2020-2021, we do not expect it to become a catalyst for negative rating actions in 2022.

2. Will inflationary pressures negatively affect public power and electric cooperative utilities' ratings in 2022?

Energy Information Administration data indicate that across all ownership classes of utilities, following 2021's sharp increases in natural gas prices, retail electricity rate increases were at or below the national inflation rate in more than two-thirds of the U.S. states.

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In 2022, we will continue to monitor whether:

• Fuel and purchased power hedging arrangements will continue to shield utilities from inflationary pressures;
• Utilities are recovering costs from customers in a timely manner and preserving a sound alignment among revenues, expenses, and debt service; and
• Rates remain affordable and utilities retain ratemaking flexibility as they adjust rates to capture inflationary pressures and finance capital needs.

What we think and why

Inflationary pressures color utility operating costs and financial flexibility.  The 2021 surge in consumer prices represents a 39-year high on an annualized basis. The scope of inflationary pressures on utility operations encompasses labor costs, capital investments, and key electricity production inputs including fuel. Most of the public power and electric cooperative utilities we follow have autonomous ratemaking authority, including automatic cost pass-through mechanisms, that facilitates responses to changing circumstances. Nevertheless, sharp retail rate increases could erode financial flexibility and cost recovery, which could have negative rating effects.

Where utilities lack autonomous ratemaking authority, S&P Global Ratings has a generally favorable view of rate-regulated public power and electric cooperative utilities based on regulators' legal obligation to provide for the recovery of prudently incurred costs, plus a return. Yet, delayed rate relief could negatively affect ratings.

Sizable increases in natural gas prices as a barometer of inflationary pressures.  We view recent months' natural gas price jump as a barometer of the inflationary pressures facing not-for-profit electric utilities. Over several years, natural gas's contributions to electricity generation in the U.S. have increased markedly (chart 4). Its role as an increasingly important production input compounds the runup in natural gas prices since March 2021 (chart 5). The higher reliance on this key production input whose price has doubled in less than a year presents an exposure to retail rate affordability and financial performance. The EIA projects an annual average Henry Hub natural gas price of $4 per million Btu in 2022.

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The growth in natural gas's costs and contributions to electricity production does not only affect owned generation. Power purchases under power purchase agreements or from wholesale power markets are also under the influence of the increases in natural gas prices.

Hedging arrangements are helping insulate utilities and their customers from higher costs.  At many utilities, hedging arrangements that locked in gas and purchased power prices at moderate levels have helped shield utilities and their customers from commodities' pronounced price increases. If other operating costs are stable, they can help dilute the inflationary pressures on natural gas, power purchases, and more volatile operating costs. However, hedging arrangements are typically short- to intermediate-term arrangements. Therefore, we expect that renewing the contracts at prevailing prices could trigger a need to raise retail rates to capture elevated operating costs.

Energy Information Administration data show that in 14 states, average retail rate increases since March have exceeded the U.S.'s year-to-date inflation rate among electric utilities representing all utility ownership structures (see chart 3, above). Conversely, electric utilities in 36 states have implemented rate adjustments in recent months that are below the national inflation index. Hedges that forestall rate increases and preserve financial flexibility are credit supportive. However, where utilities with limited hedging protections opt to forego rate increases and the full and timely recovery of costs, such decisions can negatively affect ratings.

In California and throughout the West, drought conditions have hampered hydroelectric production and have triggered increased reliance on natural gas-fired generation as a substitute. EIA data show that since March, the state's utilities across all ownership classes have raised retail rates by an average of 8.2%, which is nearly 20% higher than the national inflation rate.

For public power and electric cooperative utilities in California and throughout the U.S., we will continue to monitor whether inflationary pressures impede cost recovery or erode affordability, ratemaking, and financial flexibility.

3. What role will ESG factors play in public power and electric cooperative ratings in 2022?

Responding to environmental challenges presents social and governance considerations.  ESG risks and opportunities can affect an electric utility's capacity to meet its financial commitments, including debt service. S&P Global Ratings incorporates ESG considerations into its ratings methodologies and analytics, which enables analysts to integrate the qualitative and quantitative impacts throughout our credit analysis.

In 2022, when considering environmental factors, we will remain attuned to the increasing severity and frequency of physical risks stemming from climate change and the effect on utilities' operational and financial performance. We could negatively adjust ratings where management is not acting to protect their utilities and customers from disruptive and destructive forces. Similarly, we will continue to focus on affordability as a social capital factor, particularly as utilities respond to climate change, address inflationary pressures, and bear the costs of transitioning away from carbon-intensive fuels.

What we think and why

Climate change manifestations highlight the interrelationship of ESG factors.  In 2021, several significant climate events produced hefty unbudgeted costs and operational disruptions for utilities in different regions.

• In the western U.S., extreme drought conditions curtailed and continue to curtail ordinarily economical hydroelectric production and necessitated greater reliance on more expensive conventional generation resources.
• Utilities in Texas and neighboring states incurred exceptionally high fuel and power procurement costs during the severe and protracted polar vortex of winter storm (unofficially named) Uri.
• In late summer 2021, Hurricane Ida, damaged utility infrastructure and disrupted power operations across several states extending from the Gulf Coast to New England.
• While California's public power utilities have not been cited as the trigger for 2021's many wildfires, the sector's utilities nevertheless are shouldering the costs of extensive infrastructure investments in furtherance of their state-mandated wildfire mitigation plans.

These examples of regionally diverse and impactful natural disasters indicate that maintaining sound credit quality will require utilities to proactively address these exposures to insulate operations and financial performance to ward off their effects. We expect that most public power utilities and electric cooperative utilities will pursue appropriate measures in 2022.

Credit-supportive structural features can benefit not-for-profit utilities.  Public power and electric cooperative utilities benefit from structural features that have frequently, but not universally, helped shield their finances and operations from the negative fallout of weather events that could trigger rating downgrades. For the most part, public power and electric cooperative utilities possess autonomous rate making flexibility and capital market access that enable them to fund and recover from ratepayers the costs of repairing damage caused by weather events. In addition, financial relief from the Federal Emergency Management Agency (FEMA) is frequently available to not-for-profit utilities for infrastructure damage, but not lost revenues, attributable to storm events. Yet, utilities will frequently need access to liquidity or capital markets for restoration funds as a bridge to FEMA reimbursements that tend to lag. Even where FEMA reimbursements will cover portions of storm related costs, the financial magnitude of a weather event and its duration will define whether a utility's credit rating can survive unscathed. Events like Texas's winter storm showed that the structural protections that benefit electric utilities under many scenarios will not provide adequate protections in all scenarios. Where the costs of storm damage and lost revenues eclipse financial resources, we will assess whether negative rating actions are appropriate.

Management strategies are integral to the ESG matrix.  Utility management teams are largely attuned to evolving and damaging climate patterns and are formulating and implementing strategies to mitigate exposures to wildfires, hurricanes, and freezing temperatures. Some fixes are more capable of rapid deployment than others. Many hurricane-prone electric utilities in the South and East have been pursuing storm hardening measures over several years. California utilities are executing on their wildfire mitigation plans, but it may take several years to meaningfully reduce fire exposures associated with utility infrastructure. The wildfire mitigation plans aim to simultaneously protect the safety of utility customers, provide for stable electric service, and limit the financial liability that the state's strict liability standard can impose.

We believe Texas utilities continue to face material exposures to climate-related events. Although ERCOT reports that generation owners have made significant progress in winterizing power plants, we nevertheless associate vulnerabilities with the state's natural gas infrastructure, electric and gas transmission networks, the limited interconnectivity of Texas with the electric grids of adjoining states, and the shortcomings of the market's tools for incentivizing dispatchable generation investments. A more robust generation fleet could contribute to a more stable market. Weak interconnectivity limits access to backup generation resources during emergencies. Consequently, many of the ratings we have assigned to Texas's public power and electric cooperative utilities continue to carry negative outlooks and remain vulnerable to rating downgrades.