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ESG Industry Report Card: Regulated Utilities Networks

Highlights

Network environmental risks are generally limited, reflecting the sector's pure infrastructure status.

Destructive climate change-induced events could raise credit risk for companies, especially in areas where the regulatory construct is insufficient.

The sector's exposure to social risks is significant because of the importance of regulated networks to local communities and the scrutiny they face from regulators and governments.

The ESG Risk Atlas

May. 13 2019 — To calibrate the relative ranking of sectors, we use our environmental, social, and governance (ESG) Risk Atlas (see "The ESG Risk Atlas: Sector And Regional Rationales And Scores," published May 13, 2019). The Risk Atlas provides a relative ranking of industries in terms of exposure to environmental and social risks (and opportunities). The sector risk atlas charts (shown below) combine each sector's exposure to environmental and social risks, scoring it on a scale of 1 to 6. A score closer to 1 represents a relatively low exposure, while 6 indicates a high sectorwide exposure to environmental and social risk factors (for details see the Appendix). This report card expands further on the Risk Atlas sector analysis by focusing on the credit-specific impacts, which in turn forms the basis for analyzing the exposures and opportunities of individual companies in the sector.

Environmental Exposure (Risk Atlas: 2)

We view the environmental risks to electric utility networks as generally less important credit drivers because we assess the sector based on its infrastructure rather than emissions. However, recent and more frequent physical climate change events (e.g. wildfires, storms, hurricanes, and tornadoes) have, in our view, increased the environmental risks to some networks where the regulatory construct is insufficient. For example, California's recent catastrophic wildfires have pressured the credit quality of its utilities because the regulatory construct doesn't account for the consistent and timely recovery of wildfire costs. This contrasts to Florida, where its utilities have proactively implemented storm-hardening measures and have helped implement a regulatory construct that is well equipped to deal with the timely recovery of it catastrophic hurricane costs.

For natural gas networks, gas explosions and leaks that emit greenhouse gases (GHGs) can affect biodiversity. For water networks, environmental risks center on clean water, water usage (i.e. spills and losses), and drought conditions that could affect water supply. Of the three, we believe water networks have the least exposure to environmental risks in our credit rating analysis.

Social Exposure (Risk Atlas: 4)

Amid the energy transition and decarbonization of the economy, regulated networks face multiple challenges as deliverers of power, including socially. These companies play an important role within their communities because they provide an essential service that must remain affordable and reliable (including no blackouts), are typically large local employers that sometimes have unionized staff, and often significantly contribute to the local property tax base. Regulators have been increasingly focusing on affordability, and we believe this could translate into further remuneration pressure for regulated networks, especially in countries where energy bills are already high.

Utility networks are also subject to increasing scrutiny from regulators and from governments. A network must maintain high quality standards at an affordable cost for customers--higher costs or a system disruption could trigger local criticism or political pressures.

Finally, as part of the energy transition, we believe large and cross-regional electricity network operators face significant operational challenges, including the growing role of intermittent electricity from renewables, the phase-out of base load capacity, distributed generation, and the electrification of transportation (charging stations). Grid management is thus becoming increasingly complex, with greater reliance on artificial intelligence and wider digitalization of operations.

Governance

Governance risk is best assessed on an independent company-by-company basis. One specific sector-related governance complexity is the importance of oversight and focus on sustainability, requiring interactions with various stakeholders, notably regulators.

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