Regulated electric utilities have been put on watch by credit rating agencies and are ramping up equity offerings, while near-term rate reductions take shape across regulatory jurisdictions, as the impacts of federal tax reform play out.
These moves represent the adverse consequences of the lower tax rate for regulated companies, The Brattle Group observed in a recent analysis titled, "Six Implications of the New Tax Law for Regulated Utilities."
"The first step naturally is that regulators and consumer advocates are going to want to obtain all of the benefits of reduced taxes for customers," Robert Mudge, an economist at The Brattle Group and co-author of the report, said in a phone interview with S&P Global Market Intelligence. "So, the question is ... whether that is going to incur any adverse consequences for the utilities and maybe adverse consequences for customers long term. And that could come in the form of the cash flow reductions and deterioration [to] credit metrics particularly if reductions in revenue requirement are extreme in the upfront."
Moody's on Jan. 19 notched its ratings outlook to "negative" from "stable" for 24 regulated utilities and individual holding companies pointing to the potential of reducing cash flow and increasing debt.
"So, that is a real effect at least in anticipation as the rating agencies look at these companies," Mudge said.
Duke Energy Corp., PPL Corp., Southern Co. and Entergy Corp. are among the investor-owned utilities and holding companies that have announced plans to issue or raise additional equity to strengthen credit and support their growth strategy following tax reform. S&P Global Ratings analyst Todd Shipman said on a March 1 webcast that the rating agency views this as "a positive step for credit quality and ratings."
Regulated utilities also are involved in negotiations on how to pass along tax benefits to customers.
The Brattle Group economist, however, said utilities have other potential "good" uses for the extra revenue generated by tax reform other than to return it to customers.
"That's a pretty live negotiation state by state," Mudge said. "In some cases, utilities are entering into agreements to reduce revenue requirements as quickly as possible with no other disposition of the tax savings. But in others, I think regulators are at least tolerant of considering alternative applications ... putting the money into capital expenditures that might otherwise require a new source of funds."
Net positive vs. net negative
Mudge noted that it is hard to determine right now whether tax reform will be a net positive or net negative for regulated utilities.
"I think that's kind of the irony of the whole idea of a tax cut for a regulated company. For an unregulated company, it's kind of unambiguously good. Or at least in the first instance, it increases profitability. I suppose eventually unregulated companies might compete away those tax savings," Mudge said. "But in a regulated setting, it immediately reduces the revenue requirement and therefore tightens up credit metrics. So, in the first instance, it's a challenge. The simple answer is from a cash flow perspective, it poses a challenge. There may be workarounds that mitigate that challenge, but it's in the nature of cash flow and near-term liquidity."
The lower tax rate "nets out" over the long run, he added. "It shouldn't fundamentally affect the value of a regulated company because as accumulated deferred income taxes are given back to customers, the allowed rate base on which the utility can earn a return is also increased."
Buy vs. build
The analysis also examines how the tax law may tip the balance for regulated utilities to buy rather than build.
"One factor that drives a very stark difference between regulated utilities and unregulated companies in the tax law is bonus depreciation," Mudge said.
Tax reform eliminates bonus depreciation for regulated utilities but allows 100% capital expensing for unregulated companies.
"If you take in isolation the effect of bonus depreciation, that looks as though it might tip the balance a little bit toward buying rather than building from the point of regulated utility renewables," Mudge said.
"To the degree that unregulated renewable developers are in a position to use that 100% expensing, that taken by itself is going to tip the playing field a little bit in favor of the unregulated developers," he added. "Whether that is borne out is going to depend on a lot of things that are harder to measure, such as the availability of tax equity, which stands to reason will shrink if only because the pool of tax appetite or tax liability that those banks and other companies can use to absorb renewable tax credits that will have shrunk from 35% down to 21%."
S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.
