Data center electricity demand should spark sales growth in the long-stagnant North American investor-owned regulated utilities sector.

Why it matters:  Regulated utilities will be called on to meet the fast growing electricity demands of data centers. The significant time required to expand generation capacity is likely to prove a limiting factor in data center growth.

What we think and why:  Increased electricity demand from data centers should prove generally supportive of regulated utilities' credit quality. It will also introduce new risks, notably related to funding and pressures on billing, which will have to be structured to protect existing clients from cost increases related to data center driven growth.

Utilities Should Benefit From Data Centers' Power Requirements

The rising number of data centers is generally supportive of the North America investor-owned regulated utility industry's credit quality. We expect the growth will drive electricity sales and enable the industry to spread its fixed costs over a wider base of ratepayers.

There are credit risks associated with that growth. Meeting new demand will require increased capital spending and may result in significant increases to customer bills, if the challenges are not effectively managed. Yet we believe these risks are still preferable to the sector's two-decade experience of flat to negative electricity sales growth.

And the benefits should prove lasting. We expect electricity sales growth will persist over the next several decades, providing modest tail winds for the industry's credit quality.

No Growth In Recent History Brings Higher Credit Risk

North America's investor-owned regulated utility industry has spent the past two decades being squeezed by successful efforts to improve energy efficiency. Resultant flat electricity sales, over much of the past two decades, focused the industry on efficient cost management and cost recovery with minimal regulatory lag (the delay between a utility incurring costs and recovering them from ratepayers) as the primary means to maintain credit quality.

During that period of stagnation, the industry's authorized return on equity decreased (see chart 1). Moreover, it failed to rebound in line with the more recent uptick in interest rates, with the result being increased pressure on the industry's key credit risk measures.

Chart 1

Utilities sort to reduce some of that risk by improving their track record of credit supportive rate case orders (regulator-approved rate increases) and by minimizing regulatory lag--notably by implementing forward-looking test years, multiyear rate cases, formula rates, and additional regulatory riders. For example, Michigan and Pennsylvania moved to fully forecasted test years in 2019 and 2012, respectively. Despite these efforts, the industry's ability to effectively manage regulatory risk and maintain credit quality proved challenging due to rising capital spending and the lack of growth (see "American Electric Power Co. Inc. Downgraded To 'BBB+' On Weak Financial Measures, Outlook Negative," March 4, 2024; "Alliant Energy Corp. Outlook Revised To Negative On Weak Financial Performance, 'A-' Rating Affirmed," March 1, 2024; and "Eversource Energy Ratings Placed On CreditWatch Negative Following Offshore Wind Impairment," January 11, 2024).

Data Centers Should Deliver A Return To Growth

We expect that data centers' near term proliferation will prove the catalyst for North America investor-owned regulated utilities' return to electricity sales growth. Our base-case forecast is for electricity sales to increase at a compound annual growth rate (CAGR) of about 1.1%.

We note that there is significant divergence of opinion around that forecast, with some experts forecasting sales growth as high as a 3% CAGR. Our forecast of about 1% CAGR reflects our view that systematic and careful planning across the investor-owned utility sector will likely limit its realistic capability to grow at a substantially faster pace. Furthermore, most of the sector's current capital spending plans do not yet incorporate much of the growth associated with data centers, which has largely emerged over the past year. As such, most of the incremental infrastructure capital spending associated with data centers will take considerable time, even just to complete the planning phase, and will therefore likely be implemented at a slow pace.

The expansion of utility infrastructure assets is a long-term planning process that requires permitting and siting, and is typically done at a methodical pace, not least due to regulatory approvals that often take many filings and considerable time. We expect that the pace of utility infrastructure investments will not likely fully meet the energy growth needs of the tech industry, and could therefore become a limiting factor on its longer-term growth rate.

Our U.S. technology analysts don't see power curbing cloud and AI platform revenue growth through 2025, but expect it could become a constraint later this decade. Even if that materializes, it may not affect our view on the credit quality of U.S. technology issuers, because we don't view them as dependent on cloud and AI units maintaining current growth rates. Indeed, we recently outlined our view that larger tech companies could maintain their credit worthiness even in the event of a meaningful deceleration in cloud- and AI-related revenue growth (see "U.S. Tech Earnings: Cloud Titans Bet Big On AI As Traditional Players Lag," Aug. 12, 2024).

However, even a 1% CAGR for electricity sales will likely prove transformative for the utility industry. In particular the growing number of data centers will allow the industry to spread its fixed costs over a wider base. We anticipate this will provide some cushion for the industry to effectively manage regulatory risk and maintain credit quality without necessarily requiring that every rate case order is highly supportive of credit quality.

Furthermore, while we assume moderate electricity sales CAGR, we also expect that growth rate will prove durable (see chart 2). We expect growth in data center numbers will support most of the industry's growth through to 2030, while the following decade's growth will also be supported by increased onshoring of manufacturing and wider spread adoption of electric vehicles. We also believe that a slower pace of growth over a longer timeframe will be welcomed as it should prove supportive of the industry's long-term credit quality.

Chart 2

Data Center Demand Will Not Be Uniform

While data center energy demand will prove a boon for much of the North America regulated utility industry, it will not uniformly affect all utilities. We expect that the data center- driven demand growth will predominantly be in the Southeast, Midwest, and Western U.S. The greatest concentration of data centers is likely to be around the Washington D.C. metro area, primarily benefiting Dominion Energy's subsidiary, Virginia Electric and Power & Co. (see chart 3).

Chart 3

Sales Growth Comes With Credit Risks

While the expansion of data centers represents a growth opportunity for the regulated utility industry, the industry must structure these new customer rates and contracts to ensure that the new data center customers are paying for their share of electricity costs.

Meeting the demands of relatively few but very large data center customers will require that the utility industry significantly increases its capital spending and infrastructure investments. Simply assigning a significant portion of data center-related infrastructure costs to existing residential customers would result in increased customer bills and likely put pressure on the industry's ability to effectively manage regulatory risk. Increases to customer bills typically prompts more customer complaints, which pressures regulators to limit further rate case increases, which, in turn, can negatively affect the industry's ability to effectively manage regulatory risk.

We therefore expect that increased capital expenditure associated with the growth of data centers will be primarily recovered from data center customers over decades. Such a plan comes with its own risks. For example, a technological breakthrough that reduces or eliminates the need for data centers, could eventually shift the recovery of these long-term infrastructure investments onto residential customers.

The average monthly U.S. electric bill is about $138, representing about 2.2% of U.S. median household income. We believe at such levels, the customer bill represents good value for customers relative to other typical household bills (see chart 4).

Chart 4

We consider that the industry's effective management of regulatory risk requires that electricity-customer bills are maintained at less than 2.5% of household income, and that annual energy bill increases are kept at less than 3%. Average bill increases were about 2.1% over the past decade, despite the spike in commodity prices in 2022 (see chart 5). Sharing data center-related infrastructure costs with existing residential customers would likely disrupt this paradigm, potentially leading to regulatory setbacks that could weigh on the industry's credit quality.

Chart 5

Faster growth in electricity demand, and the resulting demand for increased investment, could also test credit quality by straining the industry's key financial metrics. Currently, we expect investor-owned U.S. electric utility sector's capital spending to be at about $140 billion, with cash flow deficits of $40 billion-$60 billion. We forecast capital spending for data centers to increase the sector's annual robust capital spending by about 10%-15% per year for the next several decades (see chart 6), potentially leading to an increase in the industry's leverage and a deterioration in related financial measures.

More than 20% of the utility industry is already subject to a negative outlook on credit ratings. Also, about one-third of the industry is actively managing financial measures with only minimal financial cushion above our downgrade thresholds. We consider that for the industry to maintain credit quality it will need to finance increasing capital spending in a credit-supportive manner.

Chart 6

Data Center Demand Should Prove A Net Positive

Overall, we expect growing demand for electricity, and resulting industry growth, due to data centers will support credit quality. There will clearly be risks that the industry must effectively come to terms with. We believe these risks are manageable, though unforeseen events remain a possibility. Therefore, we anticipate the industry's credit quality is poised to benefit from the emergence of electricity sales growth for the first time in nearly two decades.

Editor: Paul Whitfield

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• Data Centers: More Gas Will Be Needed To Feed U.S. Growth, Oct. 22, 2024
• U.S. Tech Earnings: Cloud Titans Bet Big On AI As Traditional Players Lag, Aug. 12, 2024
• American Electric Power Co. Inc. Downgraded To 'BBB+' On Weak Financial Measures, Outlook Negative, March 4, 2024
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