In early 2020, S&P Global Ratings revised the outlook for the investor-owned North American regulated utility industry to negative from stable. This was the first time in more than a decade that our outlook on the sector was negative. Since 2020, downgrades outpaced upgrades by more than 3:1, weakening the median rating on the sector to 'BBB+' from 'A-', the first time ever that the median rating was in the 'BBB' category. Prior to 2020, the last year that the industry's downgrades outpaced upgrades was in 2010.

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The Impact Of ESG Factors And High Capital Spending

Credit quality weakened over the past three years primarily as a result of two developments. One is the increasing influence of environmental, social, and governance (ESG) credit factors on our credit analysis, which considers companies' exposures to such factors as climate risks or governance structure. The other is high capital spending and the failure to fund such robust spending in a credit-supportive manner. Physical risks such as exposure to wildfires, storms, extreme temperature events, and hurricanes, remains a considerable risk for the industry. In fact, over the past three years the U.S. experienced its highest level of damages ever from physical risks (chart 2). In response, the industry continues to proactively work with regulators, implementing various credit-supportive tools. These initiatives include increasing storm reserve accounts, self-insurance, securitization, system hardening, and wildfire mitigation programs. While these tools will reduce some of this risk, we expect that because of climate change, the industry will always be somewhat vulnerable to physical risks that could potentially harm credit quality.

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The industry's disproportionate greenhouse gas (GHG) emissions compared to other industries and governance deficiencies also constrained its credit quality over the past three years. In response, the industry took steps to close coal plants, significantly increase its reliance on renewable energy, and reduce its total GHG emissions. Currently, almost all the companies we rate have tangible net zero emission targets and the industry has already reduced its GHG emissions by over 30% during the past decade, which we view as supportive of credit quality.

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Over the past three years, two large companies experienced material governance deficiencies, including charges of bribery and insufficient internal controls. Since these incidents, other utilities have strengthened their internal controls, reducing the likelihood that another material governance deficiency will be identified within the industry. Overall, we believe that utilities have appropriate internal controls in place and are unlikely to experience similar problems over the next two years.

Investor-owned North America regulated utilities (electric, gas, and water) have increased their spending exponentially over the past two decades at a compounded annual growth rate of about 9%. We expect that the industry's capital spending for 2023 will reach a record at about $200 billion. We expect that utilities will even significantly increase this level of spending over the next two decades, as they step up spending on safety, reliability, energy transition programs, and on initiatives in support of electric vehicles. As a result, the industry's annual negative discretionary cash flow is expected to continue to remain consistently greater than $100 billion. Because utilities have not consistently funded these deficits in a credit-supportive manner, the industry's credit measures and credit quality have weakened.

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The Stable Industry Outlook Mirrors Improving Economic Conditions

Our outlook for the industry as a whole reflects the increasing percentage of utilities with a stable outlook, lower natural gas prices, and a slowing of inflation. At year-end 2020, about 35% of the companies we rate in the sector had a negative outlook compared with only about 14% as of May 2023. Furthermore, for the first time in years, the current percentage of utilities with a positive outlook (14%) is the same percentage of those with a negative outlook. Much of this upside reflects the financial cushion that companies have after a downgrade and the more stringent internal controls they've implemented following the identification of several governance deficiencies.

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More recently, economic indicators have gradually improved. Inflation is increasing at a considerably slower pace with April's consumer price index (CPI) at 4.9% compared 9.1% in June 2022. Additionally, natural gas prices have significantly retreated from August 2022 highs when prices at Henry Hub approximated $9 per MMbtu. These healthier economic developments are consistent with S&P Global economists' forecast of CPI at about 4.7% by year-end 2023. This economic strengthening is also important for the utility industry. When gas prices peaked during 2022, many utilities deferred the recovery of these higher costs and are only now starting to bill ratepayers. The recent drop in natural gas prices provides some customer bill cushion, allowing the utilities to bill customers for the previously deferred higher commodity costs without overwhelming the customer.

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A More Balanced Upgrade And Downgrade Scenario Going Forward

Despite the improvement in economic data, we expect inflation, rising interest rates, higher capital spending, and the strategic decision by many companies to operate with only minimal financial cushion from their downgrade thresholds to continue to pressure the industry's credit quality. Throughout 2022 and so far in 2023, the Federal Reserve has consistently raised interest rates to reduce the pace of inflation. While these actions appear to have had a positive effect on slowing inflation, there's still been a modest weakening in the industry's financial measures because of inflation and rising interest rates. An environment of continuously rising costs tends to weaken the industry's financial measures because of the timing difference between when the higher costs are incurred and when they are ultimately recovered from ratepayers.

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We expect that utilities' capital spending will continue to gradually rise over the next decade as they allocate funds for safety, reliability, energy transition programs, and to support electric vehicle initiatives. We believe the Inflation Reduction Act (IRA) that provides for long-term tax credits for renewables, batteries, nuclear power, and hydrogen, and allows for the relatively easy transferability of these tax credits, only supports our view that utilities will step up spending over the longer term. Although this growth is vital for utilities to meet their goals, if they don't sufficiently fund it in a credit-supportive manner, their credit measures and credit quality could decline.

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About one-third of the industry is strategically managing their financial performance with only minimal financial cushion, reflecting funds from operations (FFO) to debt that is less than 100 basis points above the downgrade threshold. Because utility cash flows are typically more stable than those of many other industries, this strategy of operating with higher leverage works well under ordinary economic conditions. However, when unexpected risks occur or base-case assumptions deviate from expectations, the utility's credit quality can weaken.

Although North American regulated utilities are exposed to these risks, our stable outlook on the industry takes into account improving economic conditions. We expect that over the next two years industry upgrades and downgrades will be more balanced and consistent with the sector's longer-term stable trends.