For a time, North America’s regulated utilities and merchant power generators were negotiating a market characterised by “known unknowns.” For regulated utilities, chief among them was the uncertainty around tax reform, which has now begun to be addressed. The same cannot be said for merchant generators. Management teams are pondering the extent to which energy efficiency and disruptive technology advancements will necessitate strategic modifications.
So, what is the outlook for North America’s electricity companies? On the horizon, both regulated utilities and merchant generators should remain mostly stable. For merchant power, 55 percent of rated independent power producers (IPPs) enjoy stable outlooks, though there is a negative bias on the IPPs with other outlooks. Regulated utilities, meanwhile, are also mostly stable – supported by robust regula¬tory oversight.
Although the dust has settled on the details of U.S. tax reform, North American utilities are still subject to many uncertainties. Pressure, for instance, comes from the burgeoning of renewable and battery storage capabilities and weak demand growth. That said, the industry overall appears well positioned to withstand the mild shocks emerging in the medium term.
Regulated Utilities: Short-term Shocks to Subside
Importantly, while the U.S. tax reform bill may pressure regulated utilities in the immediate term, this should subside. The reduction of corporate rates to 21 percent, from 35 percent, prompts regulated utilities to pass along their savings to customers1. This could weigh more heavily on the cash-based credit metrics. The impact will vary between companies depending on each utility’s unique tax position, but – generally speaking – we can expect cash flows to weaken. This will take place once utilities begin passing savings to the ratepayer and feel the loss of tax incentives from reforms.
This is mostly manageable, however. The effects are unlikely to be pronounced enough to prevent companies from compensating. For those companies with heightened financial risk, however, the ramifications of tax reform could spur a rating change – should they not strengthen their credit profiles. All things considered, we expect few rating actions as a direct result of U.S. tax reform. This is because regulators, we think, will continue to ensure utilities operate in a favourable environment for returns and credit quality. Of course, as unpredictable as regulatory behaviour can be, the economic conditions in many regions have enabled utility regulators to support generators’ earnings and cash flow stability.
Buoyed by these conditions, capital spending is likely to remain a focus for utility management teams as they meet infrastructure needs. These upgrades appear necessary. Regulated electric utilities are strategically modifying their generation fleets to reduce air emissions from power plants, to justify the shuttering of aging coal plants and to replace carbon-emitting plants with lower or zero-emission sources. As part of this, utilities are moving away from bigger, base load generators (namely coal and nuclear) to more modular and scalable renewable sources.
Amid industry disruptions, merger and acquisition (M&A) activity could increase. Now that the uncertainties surrounding tax reform are removed, determining the value of utilities (and necessary capital costs) is becoming more certain, too. With capital costs still below historical averages, a flurry of transactions could appear this year. Increasingly popular for North American gas and electricity utilities are cross-industry and cross-border acquisitions – a trend that could continue during 2018.
Merchant Generators: Headwinds Ahead?
The greatest influence on merchant generators’ credit quality, meanwhile, will likely be electric demand growth (or lack thereof). Most merchant generators have blamed waning growth on the milder weather over the past two-to-three years. In turn, almost all generation forecast models factor in demand growth between 0.75 percent and 1 percent – a seemingly optimistic expectation, pinned on hope rather than a business strategy.
As such, we believe the most significant risk to merchant energy margins and capacity price assumptions is a decline in secular demand growth. And, for the time being, estimating the severity of the impact of faltering demand is proving troublesome. Implied load in the PJM auction, for instance, has fallen over the past four years – leaving a negative 1.2 percent compound annual growth rate (CAGR). With demand declining, capacity prices are falling, too. Other markets are experiencing a similar trend: the 30-gigawatt (GW) ISO-NE market has grown at negative 0.5 percent for the past three years.
Further pressuring merchant generators, is the falling cost of renewable energy. Since 2009, solar PV installed system costs have fallen for residential and commercial systems and for industrial utility-scale systems, by 60 percent and 70 percent per kilowatt (kW), respectively. Wind generation has proliferated, too: for instance, wind power comprised 17 percent of the load in the ERCOT market in 2016. In turn, Exelon Generation found that round-the-clock prices at some generators in its nuclear fleet are now US$3.00/ MWh lower, largely, thanks to the competition.
Energy efficiency gains could also dim prospects. Arguably, market participants are still downplaying the potential ramifications of energy efficiency advancements. While LED lighting penetration remains low, it is expected to increase to 25 percent by 2020, from 8 percent today – leading to a 4 percent decline in power demand.
This is no inconsequential number: for perspective, the 2016 Department of Energy (DoE) report estimates that LED lighting-related savings will be approximately 325 terawatt hours (TWh) per annum in 2030, when compared to 2015 levels. And this may not be effectively offset by the advent of electric vehicles, either. Forecasts by the S&P Market Intelligence Group put power demand from car and light trucks at 172 TWh per annum by 2035. Mitigating these revenues pressures, therefore, will rise up the agenda in the longer term.
Overcoming Mild Shocks
Certainly, transformative risks abound in North America’s utility space – and this is especially true for electric utilities. The energy transition, spurred by carbon concerns and other environmental considerations, is prompting generators to pursue a more diverse energy mix.
This brings some potential upsides, too: in the regulated market, the amalgamation of growing renewables and battery storage technology presents some opportunities for growth. Though storage technology is still nascent, we expect that – as battery prices fall – utilities will evolve to meet the grid’s needs. So, despite the shocks and prospects for disruption ahead, regulated utilities and merchant generators alike only display slight downside rating exposure.
Aneesh Prabhu is a senior director in S&P Global Ratings Infrastructure Group. As a member of the Utilities, Energy and Project Finance Group, Prabhu is involved with all aspects of the Corporate Utility practice, assigning new credit ratings and conducting surveillance on electric utilities, merchant generators and project finance transactions.
He is a credit analyst for a number of merchant power companies in the Mid-Atlantic and ERCOT regions. Prabhu is also a spokesperson for the energy practice for varied topics such as merchant generation, capacity markets, nuclear retirements, renewables, liquidity & capital adequacy requirement and risk management.
Prabhu is a Charterholder of the CFA Institute and holds the Financial Risk Manager (FRM) certification awarded by the Global Association of Risk Professionals (GARP). He has an MBA from the University of Wisconsin, Madison and holds a B.Tech in electronics and communications engineering from the Indian Institute of Technology, Roorkee.
Todd Shipman is a senior director on the North American Regulated Utilities team in S&P Global Ratings. He is the sector lead on the team, playing the senior analytical, criteria and investor outreach role in Global Infrastructure Rating’s coverage of the investor-owned electric, natural gas and water utility industries in North America. Shipman also serves on the Hybrid Securities Task Force that establishes, reviews and helps implement criteria related to hybrid securities such as preferred stock. He holds an undergraduate degree in economics from Texas Christian University and a law degree from Texas Tech University.
A chartered financial analyst, he served on the board of directors of the Society of Utility and Regulatory Financial Analysts for 10 years and is a member of the Wall Street Utility Group. Shipman is also an adjunct faculty member in Boston University’s Questrom School of Business teaching advanced undergraduate courses in finance.
References
1 https://www.bloomberg.com/news/articles/2018-01-05/trump-tax-reform-has-states-hungry-for-lower-utility-bills
