S&P Global Ratings has long focused on cash flow quality metrics when determining credit risk for the investor-owned utilities that it rates. The historical and projected generation of cash flow from operations, adjusted to deduct capital spending, dividends paid, and share repurchases, is a key input into the calculation of discretionary cash flow. Given the capital-intensive nature of the utilities sector, and the consistency of dividend payments that management teams are loath to trim, we focus on the utilities' ability to manage discretionary cash flow from operations and external funding to maintain credit quality.

In practice, the majority of utilities generate negative discretionary cash flow from operations during periods of normal operations, which they offset with steady access to the capital markets for both debt and equity financing. During periods of healthy growth, funds from operations increases to offset higher debt balances that result from discretionary cash flow deficits. This allows utilities to maintain credit metrics at acceptable levels. However, ever-increasing opportunities to grow rate base through record capital spending, together with limited equity issuance, may test this balance in the years to come. Here we focus on emerging capital spending trends and opportunities facing the sector and why we think key cash flow metrics may come under pressure.

Record Capital Spending Trends Not Likely To Abate Soon

Transformative change is now well under way within the generation portfolio that North American utilities use to produce power, with increasing focus on low-carbon generation including new investments in wind and solar assets and battery storage. At the same time, traditional carbon-intensive units are either facing retirement or substantial capital improvements to comply with increasingly stringent air quality mandates or to address climate change concerns important to investors or other stakeholders. Other large-scale capital projects are aimed at hardening the grid against increasingly severe physical risks and climate events while others are geared to accommodate more diverse and intermittent power sources. Further, aging infrastructure is a pervasive issue that requires persistent management, replacement, and improvement, a trend that is fueling investments across electric, gas, and water systems from coast to coast.

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Utilities Find Abundant Rate Base Growth Opportunities In Regulated Businesses

The aforementioned trends are playing a key role in fueling record levels of spending in 2023. This pattern is not new, as total capital spending for the universe of utilities we rate increased from about $100 billion to $200 billion in little more than a decade. S&P Global Ratings generally views capital spending contained within the regulated utility business model as favorable from a business risk perspective. This spending typically heightens the company's reliance on lower-risk growth as compared to investments into higher-risk unregulated adjacent businesses.

Capital spending provides rate base expansion which in turn drives earnings gains even during periods of negative volume growth in electricity sales. (Sales volumes have been flat to negative for most of the last decade due to consistent efforts toward conservation, energy efficiency, distributed generation, and technology advancements.) Policymakers also promote higher capital spending through legislation that includes incentives to address long-range climate change objectives, as is evident in the Biden Administration's recent passage of the Inflation Reduction Act (IRA) that allows for tax credit transferability to encourage investments in renewable power generation among other incentives. The combined effect of all of these factors supports the view that the sector's appetite for ever-increasing annual capital spending is not going to end soon.

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And without some material economic disruption or rate pressures that test the will of customers and regulators, we believe that these trends are durable and will likely persist for at least the next 10 years. It also appears evident, looking at the multi-year strategic focus of the management teams we interact with that the focus on regulated utility spending (and by extension the diminished focus on other adjacent operations) has helped reduce the reliance on higher risk businesses. From a credit perspective, this is favorable in terms of our assessments of business risk, and potentially financial risk as well, assuming that management teams commit to maintain financial policies that manage any strains on balance sheets from reduced discretionary cash flows because of a greater reliance on debt.

How Utilities Account For Capital Expenditures And Rate Base Growth

Through the utility's rate case filings, the state utility regulatory commissions determine the revenue requirement necessary for the utility to recover its operating costs, taxes, debt service, and its depreciation expense (necessary to return capital deployed into its physical assets to investors). Investor-owned utilities are also authorized to earn profits on the equity rate base invested by shareholders to support operations. Rate base growth occurs through the deployment of capital into new investments and by effective regulatory management. Thus, there is an incentive and expectation that utility management teams will pursue prudent capital investments that are necessary to serve the rate payers.

While this is part of effective management, the current environment is presenting utility management teams with an expanding strategic opportunity to both strengthen the physical grid and to realize healthy profits and growth for many years to come.

Financial Policy Will Weigh Heavily On The Direction Of Credit Quality

The essential nature of utility services, and the strength of the regulatory frameworks across North America breeds a level of confidence that enables utility management teams to dial-in financial policy with a good deal of precision. They are accustomed to running with negative discretionary cash flow, and many have adopted policies that target a level of financial leverage that is just above the downgrade thresholds we communicate in our research reports. This is typically manageable but persistently high capital spending has begun to test the ability of management teams to maintain ratings while pursuing historically higher growth spending.

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Some companies have been unable to support financial metrics consistent with former ratings as their discretionary cash flow deteriorated. This trend was a significant contributor to the sector seeing the median rating decline to 'BBB+' from 'A-' for the first time in 2022. What is less clear is whether or not management teams will take steps to forestall another step down in credit quality as high capital outlays persist. So far in 2023, we have not seen evidence that equity issuance is keeping pace with debt issuance to fill ever-deepening discretionary cash flow shortfalls, but time will tell.

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Most utility management teams maintain the ability to pull levers to target financial outcomes. While this is true in any sector to some extent, utilities' operating stability supports a greater degree of precision when managing financial risk against other stakeholder objectives. The capacity and willingness to take actions to offset the potential deterioration of the balance sheet will therefore be a key focal point if capital spending continues to grow. Companies will have to consider tough tradeoffs between good capital projects, shareholder rewards, and balance sheet strength.

Could Regulators Constrain Spending To Reduce Customer Rate Pressures?

A key determinate of how durable these trends prove to be over the long term will be utilities' careful management of capital spending growth so that customer rates do not rise to the point where bills are viewed as burdensome or out of step with the value proposition of the utility services. Most utilities manage this issue very well and heretofore have argued that the value provided through their services is high and leaves room to execute current plans.

Management teams take great care to manage the regulatory relationships with the state utility commissions to strike the appropriate balance between effective grid updates and the costs to achieve these objectives. Well-run utilities place great emphasis on operations and maintenance cost management to reduce the burden on rate payers and proceed with new projects. Nonetheless, elevated spending, particularly in an inflationary environment, is likely to add further strain to regulatory proceedings.

Load growth, something we have not seen for many years, and potentially bolstered by electrification trends, new investments related to green hydrogen or energy-intensive technologies, and the future of electric vehicle growth, can also help to offset this pressure at the margin in some service territories. The more likely scenario is that modest load growth will continue to be offset by efficiency gains and the unwavering increase in capital spending has the potential to bring higher rates to many customers. This will require prudent management to ensure rate pressures remain reasonable so as not to strain the utility's regulatory relationship.

Stable Outlooks Could Turn Negative As The Capital Spending Boom Persists

Earlier in 2023, S&P Global Ratings noted that its outlook for the industry as a whole is stable, supported by the percentage of utilities with a stable outlook, lower natural gas prices, and a slowing of inflation. Even now, about 68% of outlooks in the sector are stable, with negative and positive outlooks at 17% and 15%, respectively. These data points suggest a period of ratings stability for the next year or so following a step down in credit quality during 2022.

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Despite the improvement in the economic outlook, we expect inflation, high 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. We are cautious about the durability of the current stable ratings outlook given persistently high capital spending that now supports a trend of deterioration in discretionary cash flow. Without a commensurate focus on balance sheet preservation through equity support of discretionary cash flow deficits, limited financial cushions could give rise to another round of negative rating actions. The question then comes back to management priorities and financial policy decisions, or utilities may be faced with another step down in the median ratings.