Key Takeaways
- For the second consecutive year rating downgrades outpaced upgrades for the investor-owned North American regulated utility industry, causing the median rating on the industry to fall to the 'BBB' category.
- During 2021, credit quality was primarily pressured by weak financial measures and Environmental, Social, and Governance (ESG) credit risks. We expect that these risks will continue to pressure the credit quality of the industry in 2022.
- Our outlook on the investor-owned North American regulated utility industry remains negative. We believe that 2022 could be the third consecutive year that downgrades outpace upgrades.
- Recently, several new credit risks have emerged, including inflation, higher interest rates, and rising commodity prices. Persistent pressure from any of these risks would likely lead to a further weakening of the industry's credit quality in 2022.
Credit quality again weakened in 2021 and represented the second consecutive year that downgrades outpaced upgrades. Prior to 2020, the last time downgrades outpaced upgrades was 2010, reflecting a near decade of consistent improvement to credit quality.
During 2021 downgrades were primarily the result of weak financial measures and ESG-related credit risks. We downgraded Atmos Energy Corp. (A-/Negative/A-2), Duke Energy Corp. (BBB+/Stable/A-2), One Gas Inc. (BBB+/Negative/A-2), Entergy Louisiana (BBB+/Stable), and Entergy New Orleans LLC (BB/Developing/--) primarily because of rising environmental or physical risks. Conversely, downgrades to National Grid North America Inc. (BBB+/Stable/A-2), Southwest Gas Holdings Inc. (BBB-/Negative/--), Southern Co. (BBB+/Stable/A-2), and Pinnacle West Capital Corp. (BBB+/Negative/A-2) primarily reflected weak financial measures.
ESG credit risks and weak financial measures similarly affected the outlooks on several utilities. We revised the outlook on OGE Energy Corp. (BBB+/Negative/A-2) to negative from stable reflecting physical risks while the outlooks for Algonquin Power & Utilities Corp. (BBB/Negative/--), American Electric Power Co. Inc. (A-/Negative/A-2), Cleco Corporate Holdings LLC (BBB-/Negative/--), and Evergy Inc. (A-/Negative/A-2) were all revised to negative from stable because of relatively weak financial measures for their current rating.
Chart 1
Because the industry has experienced such a significant weakening of credit quality over the past two years, the median and modale ratings for the industry fell for the first time ever to the 'BBB' category from the 'A' category. In 2021 the percentage of companies in the 'A' category dropped to 45% from 58% in 2020 and the percentage of companies in the 'BBB' category increased to 51% in 2021 from 34% in 2020. Despite the overall weakening of credit quality in 2021, there were some areas of improvement, specifically, the number of high-yield companies decreased in 2021 to about 2% from about 7% in 2020. However, this is mostly attributable to the multiple notch upgrades related to FirstEnergy Corp. (BBB-/Stable/--), which reflected the significant steps the company took to remediate the material weakness identified within its internal controls. We believe that this strengthening in credit quality is limited to FirstEnergy and is not reflective of the broader industry risks.
Chart 2
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Industry Credit Quality Will Likely Continue To Weaken in 2022
A relatively high percentage of the industry (about 20%) continues to have a negative outlook. While this is materially lower than the approximate 35% of the industry with negative outlooks at year-end 2020, it remains elevated compared to historical averages (approximately 10%). Conversely, the positive outlooks are at just about 5%. As such, we believe it is more likely that downgrades will continue to outpace upgrades in 2022.
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What's Behind This Fundamental Weakening Of Credit Quality?
Utility cash flows tend to be more stable and predictable than most other industries. Strategically, an increasing percentage of the industry has been managing their financial measures with only minimal financial cushion from their downgrade threshold. While this strategy of limiting excess credit capacity works well under ordinary conditions, when unexpected risks occur or base case assumptions deviate from expectations, the utility can become susceptible to a weakening of credit quality. This has been one of the primary drivers of the industry's weakening of credit quality over the past two years.
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Dealing With Energy Transformation
The utility industry has already made significant progress towards reducing its greenhouse gas (GHG) emissions. Over the past decade, the industry reduced its reliance on coal-fired generation by more than 50% and more than doubled capacity from renewable energy. Because of these transformative trends, the industry's GHG emissions have decreased by more than 25%. Despite these milestones, the industry continues to invest heavily in renewable energy, which will further reduce its GHG emissions by about 40% over the next decade.
Chart 7
We anticipate that it could take longer than a decade to transform the U.S. generation portfolio, increasing our reliance on renewable energy for more than 50% of total generation. As such, we expect that capital spending will remain robust for the foreseeable future, continuing to pressure the industry's financial measures. Because of the robust capital opportunities available to many companies within the industry, utilities will continue operate with only minimal financial cushion from their downgrade threshold.
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Capital Spending
We expect 2021 capital spending to approximate $170 billion setting a new record for the sector. This is about 5% higher than the $164 billion spent in 2020 and about 9% higher than the $157 billion spent in 2019. Over the past fifteen years, the industry's capital spending has been growing at a compounded annual growth rate of about 9%. While we expect the growth rate will somewhat slow, we still expect that the industry will continue to grow its capital spending. Under our base case, we expect that by 2024 the industry's capital spending will exceed $180 billion. Because of the industry's continued robust capital spending, we expect that industry will continue to generate negative discretionary cash flow. This requires that the industry has consistent access to the capital markets to finance capital spending and dividends requirements.
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ESG Credit Risks
During 2020 and 2021 the industry credit quality was constrained by many ESG-related credit risks. Unexpectedly, the industry faced several governance-related credit risks in 2020. We view these governance events as isolated incidents and do not believe that they will have broader implications for the larger utility industry. However, we do expect that physical and environmental risks will continue to constrain the industry's credit quality. Wildfires, severe winter storms, hurricanes, and tornadoes lead to higher costs that are either partially disallowed by regulators or are deferred for future recovery. Similarly, higher environmental costs can also result in higher costs that are either partially disallowed by regulators or are deferred for future recovery. Either outcome for physical and environmental risks typically results in weaker financial measures until the utility fully recovers such costs from customers. Because of climate change, we believe that these risks will continue to negatively affect credit quality in 2022.
Other Developing Risks That May Affect Credit Quality
Inflation, higher interest rates, and rising commodity prices could all lead to higher customer bills, pressuring the industry's ability to effectively manage regulatory risk and its credit quality. Inflation recently spiked to its highest level in decades after rising for several consecutive months in 2021. Given the sustained increase to the U.S. consumer price index in 2021, inflation no longer appears to be just transitory and may have financial implications for the investor-owned North American regulated utility industry. Because of the regulatory lag within the industry, inflation, which causes prices to rise, typically leads to a weakening of financial performance. The regulatory lag is the timing difference between when costs are incurred and when regulators allow those costs to be fully recovered from ratepayers.
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Similarly, when interest rates rise, the industry's finance measures also typically weaken because of regulatory lag. Commodity prices have also materially increased over the last several months, which could cause credit quality to weaken. While commodity costs are typically directly and fully collected from customers, high commodity costs increases the customer bill, which would likely make it more difficult for the industry to effectively manage regulatory risk. We believe persistently higher natural gas prices would pressure credit quality and the customer bill for natural gas distribution utilities. Furthermore, about 40% of the U.S. generation portfolio is from natural gas fired generation and therefore persistently higher natural gas prices would likely also pressure the credit quality of electric utilities.
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The Industry Outlook Remains Negative
Credit quality for the investor-owned North America regulated utility industry weakened during 2020 and 2021 with the median rating falling for the first time ever to the 'BBB' category. Given the relative high percentage of the industry with a negative outlook (about 20%), the strategic management of financial measures with only minimal cushion from the downgrade threshold, the industry's high capital spending, ESG credit risks, inflation, rising interest rates, and higher commodity prices, we expect that it is more likely that downgrades will again outpace upgrades in 2022. Should this occur, it would be the first time in more than 30 years that downgrades outpaced upgrades for three consecutive years.
This report does not constitute a rating action.
| Primary Credit Analyst: | Gabe Grosberg, New York + 1 (212) 438 6043; gabe.grosberg@spglobal.com |
| Secondary Contact: | Minni Zhang, New York; minni.zhang@spglobal.com |
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