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An Old Age Problem? While North American Regulated Utilities’ Credit Measures Could Dip On Pension Underfunding, Cost Recovery Ability Supports Credit Quality

An Old Age Problem? While North American Regulated Utilities’ Credit Measures Could Dip On Pension Underfunding, Cost Recovery Ability Supports Credit Quality

Many utilities are proactively managing the risks of an aging workforce. Associated with this risk is the level of funding for PRBOs. Over the past decade, funding levels have gradually improved, reflecting company contributions, market returns, and benefit modifications. At year-end 2019, the industry's net PRBOs were manageable, with average funded levels greater than 80%, which provides some flexibility for short-term asset value declines and adverse liability revaluations, such as what we'll likely see during this economic downturn.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: As the situation evolves, we will update our assumptions and estimates accordingly.

Chart 1


As PRBOs represent a future call on cash that provide no future offsetting operating benefit for corporations, S&P Global Ratings increases its adjusted debt figures for corporate entities for the underfunded PRBO net of tax benefits. Some of the critical assumptions we use in determining the underfunded level include asset returns, company contributions, and discount rates.

Currently, S&P Global Ratings is projecting a 12.7% decline in the S&P 500 for 2020 (An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020). As COVID-19 has contributed to broader market turbulence during the early part of 2020, we expect that lower asset valuations and a lower discount rate will cause us to increase our PRBO debt adjustment for the utility industry, leading to weaker credit measures. For our analysis, because a significant portion of postretirement assets are invested in fixed income, we project that the industry's 2020 postretirement assets have declined by only about 5%, using current market returns through early April. Our analysis is based on 2019 data for 90 publically disclosed utility companies, which, on average, had an allocation for their postretirement funds to equity securities (40%), fixed income securities (38%), real estate (2%), and other alternative assets (20%).

Chart 2


We also expect higher PRBOs because of a lower assumed discount rate used to determine the obligations. The use of a lower discount rate increases PRBOs on the balance sheet. As a result, our adjusted debt for corporates rises, thus weakening credit measures. High-investment grade corporate bond yield curves, which are often used as a proxy for utility companies when determining the discount rate of their PRBOs, have moved downward in 2020. This is also consistent with our projection for 10-year treasury yields to end 2020 at 1.1% (An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020), which is lower than the 1.8% yield at year-end 2019. Using the current change in the 'AA' corporate bond yield curve from year-end 2019 as a proxy, we estimate that the discount rates used to value many of the postretirement obligations could fall by 0.25%. Based on public disclosures, we estimate, that a 0.25% decline in discount rates corresponds to about a 3% increase in gross PRBOs.

Chart 3


When compounding the impacts of declining asset values and lower discount rates (assuming ongoing service and interest costs and potentially lower contributions in 2020), we estimate that net postretirement obligations could increase by about 100% and that PRBO funding ratios for utilities could decline by an average of about 10%. Based on our analysis, we expect that the North American regulated utility industry's FFO to debt will weaken by about 50 basis points. However, we do not expect a uniform weakening of credit measures. For about two-thirds of the industry where PRBOs do not represent a material portion of total adjusted debt, we expect that FFO to debt will only deteriorate by about 30 basis points. We expect that the credit measures for utilities that have pension liabilities representing a higher percentage of total adjusted debt will be most negatively affected.

The 20 North American Utilities With The Largest Postretirement Obligations As A Proportion Of Total Adjusted Debt
Company PRBO as a percentage of total adjusted debt (2018) Net PRBO (mil. US$)*

Ontario Power Generation Inc.

41.50% 5,219

Connecticut Natural Gas Corp.

29.30% 103

The United Illuminating Co.

19.40% 261

Unitil Corp.

16.80% 143

Otter Tail Corp.

16.50% 170

Southern Connecticut Gas Co.

16.50% 74

Oncor Electric Delivery Co. LLC

16.10% 1,764


15.70% 525

Hawaiian Electric Industries Inc.

15.10% 527

New York State Electric & Gas Corp.

14.50% 271

Commonwealth Edison Co.

14.30% 1,979

Southwest Gas Corp.

13.70% 425

Exelon Corp.

13.30% 6,395

Central Maine Power Co.

12.30% 192

Cleco Power LLC

12.10% 275

Southwest Gas Holdings Inc.

12.00% 425

Rochester Gas & Electric Corp.

11.50% 175

Avangrid Inc.

11.20% 1,107

Evergy Metro Inc.

11.10% 487

Baltimore Gas & Electric Co.

10.60% 446
Note: Companies only included if the debt adjustment had a direct impact on the rating, i.e., noninsulated subsidiaries were excluded. *Latest available data as per S&P Global Ratings. PRBO--Postretirement beneift Obligations. Source: S&P Global Ratings and company data.

Effect On Credit Quality In 2020

We expect that the current recession and changes to key pension assumptions will result in modestly weaker financial measures for the North America regulated utility industry. However, we don't expect this will directly lead to a deterioration of the industry's credit quality though it may add incremental pressure to issuers that are already under strain from weak metrics. Still, most companies that have large postretirement obligations as a proportion of total adjusted debt--whose credit measures will likely be most affected by these changes--will not experience a material weakening of credit quality. On a qualitative basis, we assume that utilities will continue to fully recover pension costs and obligations through their ratemaking process. This is based on decades of almost full recovery of such costs with very few exceptions over this timeframe. We also note the North America regulated utility industry's long history of effectively managing regulatory risk. As such, we expect no direct deterioration in credit quality due to pension underfunding over the next year, despite an expected modest weakening to the industry's credit measures in 2020.

This report does not constitute a rating action.

Primary Credit Analysts:Sloan Millman, CFA, New York + 1 (212) 438 2146;
Gabe Grosberg, New York (1) 212-438-6043;
Secondary Contact:Shripad J Joshi, CPA, CA, New York (1) 212-438-4069;

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