Key Takeaways
- We are updating our 2024 outlook on the investor-owned North American regulated utility industry to negative.
- Given the relatively high percentage of companies with negative outlooks, we expect that 2024 will likely be the fifth consecutive year that downgrades outpace upgrades.
- The industry faces rising physical risks and high cash flow deficits that may not be sufficiently funded in a credit-supportive manner.
- Still, we expect that the utility industry will maintain a median investment-grade rating of 'BBB+'.
- We also expect that a smaller percentage of companies rated 'BBB' or lower are more likely to implement measures to maintain or even improve credit quality.
Credit quality for North American investor-owned regulated utilities has weakened over the past four years, with downgrades outpacing upgrades by more than three times. We expect downgrades to again surpass upgrades in 2024 for the fifth consecutive year. In the decade prior to 2020, upgrades generally outpaced downgrades in the industry.
Chart 1
High Percentage Of Negative Outlooks
Currently, about 28% of the industry has a negative outlook or is listed on CreditWatch with negative implications. This is now the third time in the past five years that the year-end percentage of negative outlooks and CreditWatch listings has exceeded 20%. Given the current high percentage of negative outlooks it is increasingly likely that credit quality will again weaken in 2024.
Chart 2
Future rating actions are typically correlated with our outlooks. The industry's share of negative outlooks reached a record high of 35% at year-end 2020, and the following year saw a record 43 downgrades. The industry's current percentage of negative outlooks is significantly larger than it was at year-ends 2021 and 2022, when downgrades still materially outpaced upgrades the following year. As such, given the current high percentage of negative outlooks, we anticipate that 2024 will be another challenging year for the industry's credit quality.
Chart 3
Median Credit Rating To Remain Investment Grade
The median rating among North American investor-owned regulated utilities is 'BBB+'. Despite our expectations for downgrades to again outpace upgrades in 2024, we expect that the median rating will remain 'BBB+'. To weaken the median rating to 'BBB', the industry would need about 70 downgrades to 'BBB' from the 'BBB+' level or above. This degree of credit weakening is well above our base-case expectations for 2024. However, this magnitude of weakening could occur over the next three years if this negative pace persists.
Chart 4
Headwinds To Credit Quality
The industrywide negative outlook reflects rising physical risks as well as financial measures, which are weakening due to rising capital spending and cash flow deficits that are not funded in a sufficiently credit supportive manner. Furthermore, much of the industry operates with minimal financial cushion from their downgrade threshold. This increases the susceptibility to a downgrade if negative events occur beyond our base case.
Increase in physical risk
Climate change and an increase in wildfire risks are threatening credit quality. Wildfire risk was generally limited to California utilities just five years ago but has spread over the past several years.
Chart 5
Since 2020, the number of structures destroyed by wildfires in Colorado, Hawaii, Idaho, Oregon, Washington, and Texas have all increased by more than 100% compared to 2016-2019. Meanwhile, Arizona, Montana, and Utah have each experienced increases of at least 20% over the same timeframe. Additionally, areas designated as high fire risk continue to increase across the Western U.S. due to climate change. To reduce these risks, many utilities are actively implementing mitigation plans designed to reduce wildfire exposure and litigation risks.
Increase in capital expenditure and cash flow deficits
The industry's capital spending remains at record levels, supporting initiatives for safety, reliability, energy transition, and growth. We consider these trends long term and expect that capital spending will only continue to increase over this decade.
Chart 6
Accordingly, cash flow deficits have increased, pressuring the industry's credit quality. For 2024, our base case assumes that the industry will fund its approximate $85 billion of cash flow deficits with about $40 billion in asset sales and equity issuance.
Chart 7
For 2023, the industry's actual equity issuance was considerably below our expectations, resulting in a weakening of financial performance and credit quality. If this trend persists, credit quality will again likely experience pressure in 2024.
Chart 8
Strained financial cushion
About 35% of the industry is sustaining performance with minimal financial cushion, reflecting funds from operations (FFO) to debt that is less than 100 basis points (bps) above their downgrade threshold. The limited financial cushion affects a company's ability to absorb unexpected events beyond the base case for our ratings, increasing its susceptibility to a downgrade. Such unexpected events include higher interest rates, changes to inflation, delays to offshore wind projects, and rising taxes.
Upcoming debt maturities amid higher interest rates
The industry has considerable near-term debt maturities that must be refinanced, as well as rising discretionary cash flow deficits that are mostly funded with debt. Because of the regulatory lag, which is the timing difference between when a utility incurs costs and when it's recovered from ratepayers, rising interest rates weaken financial performance. S&P Global economists expect the federal funds rate will stabilize in 2024 and then begin to modestly decrease. Accordingly, as interest rates stabilize, it will ease pressure on the industry's financial performance.
Additionally, the spread between the 10-year treasury and the average authorized return on equity (ROE) has narrowed. Over the past three years, the 10-year treasury has increased by about 250 bps to about 4.0% from about 1.5% at year-end 2020. At the same time, average authorized ROE has essentially remained flat at about 9.5%. The narrowing of this spread directly hinders the industry's financial performance.
Elevated inflation rates
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) costs that could weaken financial performance. While some utilities have interim mechanisms that reduce the regulatory lag, most will have to file rate cases on a more frequent basis if inflation remains higher over the longer term.
Delayed renewable energy projects
Recently, several large offshore wind projects were delayed or canceled because of rising costs for these more challenging projects. For example, we recently placed Eversource Energy's ratings on CreditWatch with negative implications directly related to its share of higher costs associated with its offshore wind projects.
Alternative minimum tax (AMT)
The Inflation Reduction Act of 2022 includes a 15% corporate AMT that we expect will weaken the financial measures of only about 10% of the industry. This is because the ATM is applicable to corporations with at least $1 billion of income that also do not have sufficient offsetting tax credits. Accordingly, we expect that most fully integrated large utilities with a growing or significant renewable generation portfolio will use their renewable tax credits to minimize or eliminate the AMT. However, the AMT could weaken financial measures of large electric transmission and distribution utilities, large natural gas local distribution companies, and large water utilities.
Lower-Rated Companies Will Likely Protect Credit Quality
We expect a majority of the industry's future downgrades will come from companies that are currently rated 'BBB+' or higher, as about 30% of companies in this category have a negative outlook. Overall, these higher-rated companies account for about 75% of the industry's portfolio. Conversely, we expect companies rated 'BBB' or lower will likely take measures to support or improve credit quality. This reflects the more than 30% of companies in this category that have a positive outlook.
Consequently, there is a broad industry trend that is bifurcating higher-rated and lower-rated companies that will likely result in weakening credit quality for the higher-rated companies and stable to improving credit quality for the smaller percentage of lower-rated companies. We believe this trend is consistent with the industry's current economic conditions of robust growth, cash flow deficits, and higher interest rates. Some higher-rated companies are determining that, under current conditions, they have excess credit capacity while lower-rated companies believe it is most optimal for them to operate at a higher rating.
Chart 9
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: | Paul Montiel, New York; paul.montiel@spglobal.com |
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