Chart 1

In 2022, rising commodity prices combined with inflation, brought an increase in average U.S. customer bills by a staggering 13% on a nominal basis and 5% on an inflation-adjusted (real) basis (see chart 2).

Chart 2

These rising costs continue to pressure the customer bill and hamper the industry's ability to effectively manage regulatory risk. As the customer bill rises, regulators may issue somewhat less constructive rate case orders to balance the interests of all stakeholders, including customers, potentially hurting the industry's credit quality. We've examined some of the key drivers for such rising costs, including growing capital spending for energy transition and system hardening, physical risks, supply chain pressures, inflation, interest rates, and volatile commodity costs, and their effects on credit quality.

How The Industry Is Managing Energy Transition

The industry continues its long-term transition to reduce greenhouse gas emissions by growing renewable energy and closing its coal-fired generation. Over the past decade more than half of the U.S.'s coal generation capacity closed and we expect that by 2040 almost all of the remaining coal plants will retire. Meeting these goals requires a thoughtful multi-decade expansion of renewable energy and battery storage, contributing to the industry's robust capital spending. Simultaneously, companies have had to align the depreciation and retirement of coal assets to avoid under-recovery or stranded assets. Although we expect companies will proactively minimize the impact to the customer bill by making use of renewable tax credits and reducing costs, given the extent of the transformation, maintaining credit quality could still be challenging.

In 2021, the Arizona Corporation Commission (ACC) disallowed Arizona Public Service Co. (APS) from recovering about $215 million related to spending on selective catalytic reduction (SCR) equipment at the company's Four Corners coal-fired power plant. We viewed this development as negative for credit quality. As such, S&P Global Ratings lowered its rating on parent Pinnacle West Capital Corp. and its utility APS to 'BBB+' from 'A-', and assigned a negative outlook on both entities.

Subsequently, APS appealed this rate case decision to the Arizona Court of Appeals and in March 2023, the court vacated the ACC's disallowance of the SCR investment and remanded the issue to the commission. In mid-2023, the ACC revised its order, authorizing APS's rate recovery of the $215.5 million SCR costs through a rate surcharge beginning July 2023. We continue to monitor future developments, including the company's pending rate case filing.

In March 2023, Kentucky passed Senate Bill 4, which prohibits the Kentucky Public Service Commission (KPSC) from approving utility requests to retire coal-fired electric generation resources unless the utility demonstrates that the retirement will not negatively affect customer rates or grid reliability. We believe this law could increase the challenges for Kentucky's utilities to effectively manage regulatory risk while closing older power plants and replacing them with cleaner energy.

Shortly after the law was passed, PPL Corp.'s Kentucky utilities filed for the retirement of about 1,500 megawatts (MW) of coal-fired capacity and about 50 MW of natural gas-fired generation by 2028. The utilities plan to replace these plants with two natural gas-fired facilities, 1,000 MW of solar capacity, and 125 MW of battery storage. We expect a KPSC decision on these requests toward the end of 2023 and will continue to monitor these developments.

New Mexico is another state in which utilities could be affected by rising credit risks associated with energy transition. In March 2021, Public Service Co. of New Mexico (PSNM) filed an application seeking New Mexico Public Regulation Commission's (NMPRC) approval to divest and transfer its 13% ownership interest in the Four Corners plant to the Navajo Transitional Energy Co. (NTEC) at the end of 2024 and to securitize the $300 million in transition bonds to finance its exit. In December 2021, the NMPRC rejected the utility's proposal and PSNM appealed the decision to the New Mexico Supreme Court.

Subsequently, in July 2023, the New Mexico Supreme Court upheld the 2021 NMPRC order, denying PSNM's sale of its interest in the plant, preventing the company from abandoning the facility and securitizing the unrecovered costs. We expect that the NMPRC's denial of PSNM's request will delay the company's exit from coal, which could increase PSNM's environmental risks.

Physical Risks Loom Large

Climate change has contributed to a significant increase in the number of adverse weather-related events like wildfires, severe storms, and hurricanes since 2018. The IOUs face resultant credit risks, among them rising system restoration costs. These expenditures lead to higher debt levels because of regulatory lag--the timing difference between when the higher costs are incurred and when utilities ultimately recover them from ratepayers.

In early 2021, severe weather, particularly Winter Storm Uri, drove electricity and natural gas prices in the southern U.S. to extraordinary levels. Utilities deferred collecting these unusually high costs from their customers, and in the process increased debt to fund these costs, thereby leveraging their balance sheets and weakening financial measures.

As a result, S&P Global Ratings downgraded Atmos Energy Corp. and ONE Gas Inc. and revised the outlook on OGE Energy Corp. to negative from stable. Similarly, during 2020 and 2021 Entergy Louisiana LLC and Cleco Power LLC incurred higher energy costs as a result of Winter Storm Uri along with severe damages to their distribution and transmission systems due to a series of hurricanes. Because of weaker financial measures from these physical events, S&P Global Ratings downgraded Entergy Louisiana to 'BBB+' from 'A-' and revised the outlooks on Cleco Power and its parent, Cleco Corporate Holdings LLC to negative from stable.

Focusing On Grid Hardening And Undergrounding

To reduce risks and costs associated with severe weather events, utilities are investing in system resiliency and hardening to strengthen service reliability, reduce outages, and reduce storm damages. Although grid hardening initiatives usually require significant capital expenditures, resilient infrastructure that withstands severe storms is likely the most effective means to reduce risks related to climate change. Below we discuss several examples of utilities' investments in grid hardening and system resiliency.

Florida Power & Light Co. (FP&L)

FP&L is exposed to severe storm and hurricanes. In 2018, the company began a pilot undergrounding project to improve resiliency. By year-end 2021, it had hardened or undergrounded more than 65% of all main distribution power lines. The company also replaced wood transmission structures with concrete or steel. FP&L plans to continue spending about 15% of its total five-year capital plan--or $5 billion to $6 billion--for storm hardening. We view the undergrounding of electricity lines in higher-risk areas as supportive of credit quality, increasing the company's resiliency toward hurricane risk, reducing customer outages, and improving reliability.

Pacific Gas & Electric Co. (PG&E)

PG&E is currently undertaking a long-term system hardening initiative that includes undergrounding about 10,000 miles of its powerlines in its service territory. PG&E's initiative to underground powerlines in high-fire-risk areas represents the largest effort by a utility in the U.S to underground powerlines to reduce its wildfire risks. From 2019 to 2022, the company undergrounded approximately 300 miles. We expect the company will underground an additional 350 miles in 2023.

Entergy Corp. and its subsidiaries

These companies, which are mostly located around U.S. Gulf Coast, have experienced higher storm risks than most other utilities. They incurred significant damages in 2020 and 2021 from hurricanes, with Entergy Louisiana LLC alone incurring approximately $2.6 billion in restoration costs. Entergy Louisiana and Entergy New Orleans LLC expect to invest approximately $10 billion and $1 billion, respectively over a 10-year period toward improving system resilience. We believe that approval of this plan would be supportive of credit quality, likely reducing physical risks for the company over the longer term.

Dealing With Supply Chain Issues

Since COVID-19, supply chain disruptions have emerged as an increasing risk for the industry. During 2020 and 2021, utilities were able to navigate these challenges by using inventory at hand. However, longer lead times to procure materials has since affected the cost and timing of capital projects. The regulatory lag associated with recovering these higher costs is increasing working capital, leading to higher leverage and interest costs for the industry. We expect that this rising risk could constrain credit quality as financial performance weakens.

In June 2022, two Wisconsin utilities, WEC Energy Group Inc. and Alliant Energy Corp., deferred the retirement of their coal-fired generating units due to a delay in the commercial operation of renewable energy projects stemming from supply chain issues. Similarly, costs for renewable projects increased for Madison Gas & Electric Co., a subsidiary of MGE Energy Inc., primarily because supply chain disruptions delayed the construction timelines for its solar energy centers. While in these instances, credit quality was not affected because the project delays were limited relative to the overall size of these companies, larger and more material delays could potentially hurt credit quality.

The Impact Of Rising Interest Rates

Since 2022, rising interest rates have increased costs for all industries, including IOUs. IOUs generally have considerable near-term debt maturities and ever higher discretionary cash flow deficits that they mostly fund with debt. That further increases costs for the industry, and pressures financial metrics. Adding regulatory lag to the mix means that these continuously rising costs weakens the industry's financial measures. We expect that higher interest rates will continue to increase costs, pressure financial measures, and over time may contribute to a weakening of the industry's credit quality.

Chart 3

Inflation Is Still A Consideration

Although the rate of inflation has slowed from 2022 levels, it remains elevated relative to historical levels. We anticipate this will result in higher operations and maintenance (O&M) and capital costs. While some utilities have interim mechanisms that reduces the regulatory lag, most will have to file rate cases on a more frequent basis should inflation remain high over the longer term.

In September of this year, rate case filings for the month reached the highest level compared to the previous five years. Companies filed 10 rate case filings (compared to the 5-year historical average of 7) totaling $334 million in requested increases or more than 13% higher than the $295 million rate increase requests in August. This suggests that the frequency of rate case filings may increase, partially reflecting rising costs from inflation. While more frequent rate case filings can reduce the regulatory lag, consistent rate case filings can lead to regulatory fatigue. This necessitates that the industry carefully balances the use of these mechanisms to effectively manage regulatory risk. We believe management of regulatory risk may have recently become more challenging in Connecticut and Kansas.

In Connecticut, the Governor recently signed Senate Bill 7 into law, which discontinued the use of the electric system improvement charge in future rate proceedings and allowed the Connecticut Public Utilities Regulatory Authority (PURA) to have discretion regarding the previous consistent implementation of decoupling. Furthermore, recent rate orders for Aquarion Co. (a subsidiary of Eversource Energy) and The United Illuminating Co. (UIC) (a subsidiary of Avangrid Inc.) significantly deviated from our base case. The orders did not approve the multiyear rate plans filed, included material disallowances, penalties for UIC, and below-average returns on equity. We view these developments as inconsistent with our view of the state's regulatory framework for investor-owned utilities. We expect that these decisions will decrease cash flow predictability and increase regulatory lag for these utilities.

Earlier in 2023, Evergy Inc. subsidiaries Evergy Kansas Central Inc. (EKC) and Evergy Metro Inc. (Metro) filed their first rate cases in Kansas since Evergy was formed in 2018. The utilities filed for net rate increases of $204 million and $14 million, respectively, and the Kansas Corporation Commission (KCC) staff recommended a net increase of $109.5 million for EKC and a net decrease of $42.3 million for Metro, which is approximately $150 million below the company's requested amounts.

Recently, Evergy's subsidiaries along with the other parties filed a unanimous settlement with the KCC, agreeing to a net rate increase of $74 million for EKC and a net decrease of $32.9 million for Metro, which is approximately $177 million below their initial request. We expect the KCC to issue an order by December 2023. Overall, we assess this settlement as negative for credit quality, reflecting a potentially more challenging regulatory environment in Kansas for its utilities.

Commodity Costs Volatility

Although commodity costs have stabilized in 2023, the high natural gas prices experienced in 2022 put a temporary squeeze on the industry's credit metrics. Utilities typically recover gas costs on a monthly basis from ratepayers, with minimal regulatory lag. However, given the dramatic increase in commodity costs, many utilities strategically deferred these costs for future recovery to minimize the near-term impact on the customer bill. While deferring costs for future recovery, physical and financial hedges, and securitization are all useful tools that can effectively smooth the customer bill from short-term commodity price volatility, there is no practical solution to longer-term and persistently rising commodity prices. Such a scenario would likely pressure both the customer bill and the industry's credit quality.

Chart 4

The confluence of higher operating costs due to rising inflation, higher interest rates, storm restoration costs, increasing capital spending, and the recovery of previously deferred higher commodity costs, has resulted in growing rate case filings and increased rate rider recovery requests from state regulators. We expect to closely monitor the industry's ability to not just recover these rising costs but to do so in such a manner that minimizes the regulatory lag. However, given the impact of these higher costs to the customer bill, the industry's ability to effectively manage regulatory risk could become increasingly challenging, possibly pressuring its credit quality.

Related Research

• Evergy Inc. Rate Case Settlement As Filed Could Weaken Credit Quality, Oct. 2, 2023
• Step Up Transformers: How Will North American Power Producers Adapt To An Evolving Grid?, Sept. 14, 2023
• Record CapEx Fuels Growth Along With Credit Risk For North American Investor-Owned Utilities, Sept. 12, 2023
• Although Commodity Costs Are A Pass Through For Utilities, They Still Affect Credit Quality, Sept. 6, 2023
• Public Service Co. of New Mexico, Aug. 9, 2023
• The Outlook For North American Regulated Utilities Turns Stable, May 18, 2023
• Evergy Missouri West Inc. Ratings Affirmed On Approved Cost Recovery, Outlook Negative, Dec. 15, 2022
• Pinnacle West Capital Corp. Downgraded To 'BBB+, Outlook Negative, On Arizona Rate Reduction, Nov. 9, 2021
• Evergy Inc. Outlook Revised To Negative On Increasing Capital Spending And Limited Financial Cushion, Sept. 30, 2021
• OGE Energy Corp. And Sub. OG&E Outlooks Revised To Negative On Unprecedented Winter Related Costs; Ratings Affirmed, March 3, 2021
• ONE Gas Inc. Downgraded To 'BBB+' From 'A' On Unprecedented Weather Conditions; Outlook Negative, Feb. 23, 2021
• Atmos Energy Corp. Downgraded To 'A-' On Weakening Credit Metrics; Ratings Placed On CreditWatch Negative, Feb. 22, 2021