The recentextension in bonus depreciation is likely to boost utility cash flows in comingyears, but in recent reports, rating agencies flag uncertainty about potential credithazards down the road.
Standard& Poor's Ratings Services issued a report March 29 in which credit analyst ObieUgboaja characterized the extension by Congress of bonus depreciation as broadlypositive for utilities. "Utilities are going to receive this increasedcash benefit that will allow them to support their increased capital spending,"Ugboaja said. "We think that increased capital spending is likely to continuebecause of things like infrastructure replacement, new generation spending, andM&A activity that we've seen in the sector recently."
But regulators in different states and jurisdictions treat bonusdepreciation differently, requiring utilities to plan carefully for the earningsimpacts of the bonus depreciation extension beyond the near-term. "Utilitieshave to somehow manage regulatory risk that is associated with the depreciation,because of the effect that it has on rate base," Ugboaja said. "So howthey manage through that with their respective regulatory environment, in theirrespective regulatory jurisdictions, will play more of a factor in the long run."
A recent report by Moody's, issued March 17, echoed those concernsthat the immediate benefit of bonus depreciation has the potential to increase long-termuncertainty when the current extension expires in 2020. When that occurs, utilitieswill have to fill the resulting cash-flow gap with a mix of new debt and equity."To the extent that utilities take on more debt than equity, the credit impactcould be negative," Moody's Vice President and Senior Analyst Jeffrey Cassellawrote.
In December2015 the U.S. Congress passeda $1.15 trillion spending bill that included five-year extensions of wind and solarinvestment tax credits, as well as an extension of bonus depreciation. The extensionallows investor-owned utilities to depreciate 50% of capital investments in 2015,2016 and 2017, then 40% of capital investments in 2018 and 30% in 2019. Bonus depreciationis a policy tool that allows companies to deduct depreciation more quickly, effectivelyaccelerating depreciation expense, and thus lowering that company's tax obligationand increasing cash flows in the near term. Companies that use this deduction wouldowe fewer taxes in the year they make a capital investment, but more during remainingyears of the asset's life.
Whilebonus depreciation benefits a utility's cash flows, because assets are depreciatingmore quickly, it generally reduces the rate base upon which regulated utilitiesearn a return.
Withthe release of fourth-quarter 2015 earnings results, numerous large cap utilitiesadjusted their earnings outlookin light of the bonus depreciation extension. Southern Co. management projected the five-year extensionof bonus depreciation would improve cash flows by roughly $4 billion through 2020,and potentially more depending on growth at its wholesale generation business, However, Southernanticipates a negative impact of 4 cents per share in 2016 due to bonus depreciation.
At , management expectsa negative EPS impact due to bonus depreciation of 9 cents in 2016, 11 cents in2017 and 6 cents in 2018. But the company also emphasized the improved cash flowthe company expects to enjoy as a result of the extension, estimating it at $625million in 2016, $675 million in 2017 and $600 million in 2018.
Amongthe 57 U.S. regulated utility holding companies Moody's rates, the agency calculatedtotal tax benefit in 2015 associated with bonus depreciation of $8.6 billion. Overthe period of 2011 to 2015, Moody's estimated a cash flow benefit through lowertaxes tied to bonus depreciation of $54 billion for that utility group. During thatfour-year period, Moody's said the utility group used the increased cash flow tomaintain a high dividend payout ratio of 60% to 70%, and increased its capital expendituresas a percentage of revenue to 29% in 2015, from 23% in 2011.
If thecurrent bonus depreciation extension expires, as currently scheduled in 2019, utilitieswill experience a combined $7.7 billion in reduced cash flows in 2020, accordingto Moody's, resulting in a cash flow difference of $16 billion for the group comparing2015 to 2020.
Mostutilities have also used the increased incremental cash flow from bonus depreciationto increase the equity component of their target capital structure, Moody's noted,without having to issue equity. As cash flow declines with the step-down of bonusdepreciation, utilities will likely compensate by issuing a mix of debt and equity."To the extent that utilities take on more debt than equity, the creditimpact will be negative," Cassella wrote. "[G]iven the limitations ondebt issuance from a regulatory standpoint, we expect that utilities will need toissue a higher proportion of new equity in order to meet any funding shortfalls."
But when bonus depreciation recedes, many utilities will havetools at their disposal to manage the increased tax burden including: net operatinglosses, carry forwards and production and investment tax credits. Moody's notedTECO Energy Inc. had anNOL and alternative minimum tax credit of about $570 million as of Dec. 31, 2015.With its large renewable portfolio, NextEraEnergy Inc. had $149 million of production tax credits and $89 millionin investment tax credits and deferred income-tax benefits, according to Moody'sand other utilities with substantial tax credit assets include , Edison International, Entergy Corp., PG&ECorp. and Xcel EnergyInc.
Moody's and S&P both foresee robust and growing capital spendingby utilities in coming years, with S&P expecting the utility industry's historicalfunds-from-operations improvement, due to lower taxes and interest rates, will morethan offset increased capital spending. These conditions will also help utilitiesmaintain their ratio of funds-from-operations to debt, despite growing CapEx requirements.
S&P also noted some regulators, as in Florida, treat bonusdepreciation as a kind of "cost-free" permanent financing that benefitsthe utility, but its inclusion in the utility's regulated capital structure reducesthe overall authorized rate of return. In other jurisdictions, bonus depreciationis accounted for as a build-up of deferred tax liability that offsets the rate basein future rate cases, and potentially impedes future rate base growth.
"There are regulatory implications and they vary by stateand utilities will have to manage through that," Ugboaja said. "We thinkthat capital spending is likely to continue. And so as that continues we think thatone way to mitigate the regulatory downward effect is to compensate by increasingcapital spending, and as long as that occurs then utilities can sort of manage throughany kind of potential regulatory risk that is tied to bonus depreciation."
S&P Ratings and S&PGlobal Market Intelligence are divisions of McGraw Hill Financial Inc.