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Credit FAQ: Energy Transition: The Outlook For Power Markets In The Age Of COVID-19

(Editor's Note: On June 9, 2020, S&P Global Ratings--together with S&P Global Platts Analytics and S&P Global Market Intelligence--hosted a webcast to discuss its outlook for the U.S. and European power markets. This FAQ was adapted from that discussion. The viewpoints of S&P Global Platts Analytics and S&P Global Market Intelligence appear in shaded boxes. All other responses are from S&P Global Ratings. S&P Global Ratings, S&P Global Platts Analytics, and S&P Global Market Intelligence are separate, independent divisions of S&P Global.)

With the ongoing transition toward renewable energy sources, weakening load growth, and declining fuel prices, power generators worldwide had already been facing a more uncertain period prior to the emergence COVID-19. The pandemic has changed things further and has accelerated some of these trends. The lockdown has led to a decline in power consumption, with an associated reduction in market power prices. Moreover, it has caused delays in a number of new generation projects.

As discussed in our recent webcast (see link below), many of these developments have put a strain on the creditworthiness of power producers. However, in our view, the credit risk for U.S. IPPs is somewhat mitigated by their operational diversity and countercyclical retail power operations, which provide a hedge. And while the disruption is worse in Europe because of lower demand and low power prices, the financial impact on our rated European power generators has generally been manageable so far this year. This is largely because of price hedges. The impact will be greater over 2021-2022, as the hedges are lower and the forward prices weaker than we anticipated last year. Although we expect the effects of these factors to be temporary, the credit risk for projects fully exposed to wholesale power prices has increased.

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S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

S&P Global Market Intelligence notes that while merchant spark spreads are typically low during the spring shoulder season, observed year-over-year declines (despite falling natural gas prices) are clearly attributable to further demand contraction associated with the pandemic's onset. While a modest economic recovery and an expected hot summer offer relief to strained merchant cash flows, this summer's results are unlikely to put the sector on a sustainable financial path. Looking beyond 2020, continued growth of the renewable segment will drive continued compression of spark spreads, with payments for resource adequacy growing in importance for merchant gas-fired generation.

S&P Global Platts Analytics believes that while power demand is recovering from the peak of the COVID-19 pandemic, a full return to business as usual is unlikely in 2020, as the economic impact of COVID-19 is compounded by enduring behavioral changes. Meanwhile, in the low demand environment, there have been new levels of turn-down flexibility from previously baseload generation forms such as nuclear and lignite, which has lessened the downside to wholesale power prices. We expect this heightened responsiveness to endure beyond the near term.

As for renewables investments, delays in new construction due to supply/logistics constraints will not have a long-lasting impact. Although renewables account for the majority of the current annual capacity increments and appear resilient given the unprecedented market context, S&P Global Platts Analytics notes that wind and solar growth faces some more structural challenges in the near term, which will require a stronger policy support. This support has so far emerged more clearly in Europe.

Below, representatives from S&P Global Ratings, S&P Platts Analytics, and S&P Global Market Intelligence answer questions related to the latest developments and how and they might affect the creditworthiness of power producers.

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What are S&P Global Ratings' views on the credit quality of independent power producers (IPPS)?

Through the pandemic, we have maintained positive outlooks on four IPPs. We believe the impact of the economic slowdown on IPPs has been relatively muted so far, especially compared to sectors such as oil and gas and refining. Even during such an unprecedented shutdown, it takes time for the energy juggernaut to slow. However, we believe operational diversity and countercyclical retail power operations that provide a hedge against weakness in wholesale power markets can have a significant effect on credit quality.

Given IPPs' focus on reducing leverage in recent years, the ones with a positive outlook have much healthier balance sheets and liquidity. Only Exelon Generation Co. LLC has near-term maturities; some companies' nearest maturity isn't until 2023 or 2024. Moreover, under our base-case scenario, all companies generate free operating cash flow, even after the COVID-19-related sensitivities. Arguably, their cash flow for 2020 will be lower and their financial ratios a trifle weaker than we had estimated. Still, that might not affect these companies' credit profiles because they could simply change their capital allocations to keep reducing leverage.

For an upgrade to 'BB+' from 'BB', we would expect companies such as NRG Energy Inc. and Vistra Energy Corp. to sustain adjusted debt to EBITDA of below 3.0x and adjusted funds from operations to debt of above 25%. We expect to start reviewing the IPPs with positive outlooks for possible upgrades by year-end as the economy recovers.

However, an investment-grade rating would require us to be confident that power markets will remain structurally sound and will not experience any price erosion because of decreasing loads. Based on forward curves and current hedges, there is the possibility of a 10%-15% decline in wholesale EBITDA of IPPs in 2021, before taking into account any hedging and mitigation. However, IPPs have demonstrated their ability to mitigate volatility through hedges, despite a backwardated forward curve. In fact, we believe IPPs in ERCOT are hedging for 2021 because the forward curve is still structurally strong and holding up well. For example, in its first-quarter 2020 earnings call, Vistra indicated that it is about 57% hedged for 2021, noting that nearly 70% of its EBITDA comes from ERCOT.

Nevertheless, we see the ability of IPPs to preserve future cash flow as a material risk if a second wave of coronavirus cases emerges, or if the actual path of the recovery is much slower than anticipated. There are two paths for IPPs to achieve investment-grade ratings:

  • They could continue on their leverage-reduction path such that they can sustain adjusted debt to EBITDA at or below 2.5x, which would result in an improvement in the financial risk profile category to intermediate from significant.
  • Alternatively, a relatively stable performance through the recession and some visibility on the resilience of the forward power curve could result in a category improvement in their business risk profiles.

What is the outlook for North American utilities' capital spending?

We expect annual capital spending for North American electric, gas, and water regulated utilities to be approximately $150 billion annually for the next two years. We expect that almost all utilities will work constructively with their regulators prior to the implementation of their short- and long-term resource plans. We also expect that resource planning decisions, as determined by the regulator, will reflect the customers' needs, which often factors in environmental concerns and costs.

In terms of the upcoming elections, the industry has a long history of effectively working with both Democratic and Republican administrations. We expect that the industry's annual capital spending of about $150 billion will not drastically change over the medium term, even if there is a new administration in November.

How will COVID-19 affect North American utilities' credit metrics? And how might regulators require utilities to update risk assessments or resource needs in light of COVID?

We expect that the North America regulated utility industry's FFO to debt will weaken by about 100 basis points. We will continue to assess each utility based on their own credit quality and expect that each company will maintain credit measures that are consistently above their downgrade threshold. We expect utilities and regulators will continue to learn from COVID-19. We expect that utilities will continue to assess their operational readiness, employee safety, and service reliability. However, we believe it is still too early to determine how these assessments or other policies might directly affect regulatory proceedings.

Prior to the coronavirus outbreak in North America, about 25% of the utilities had a negative outlook or ratings that were on CreditWatch with negative implications. Because of issues like tax reform, high capital spending, and M&A, credit quality was already weakening prior to COVID-19. Going forward, we believe that all utility stakeholders--including regulators--will be monitoring the potential cash-flow implications of lower sales margins because of weak power demand, and the impact of bad debt expense. This is especially the case for those utilities with commercial and industrial loads that account for a high percentage of their customer base.

Post COVID-19, will the European energy transition target remain, and will European utilities benefit from it?

With relatively solid balance sheets and already strong positions in renewables and networks, we see European utilities as well positioned to benefit from the strong push into green infrastructure, providing a defensive and sustainable growth pattern. In fact, we have not seen any material negative adjustments in infrastructure investments for the next three years on the sector as a response to the COVID-19 situation. Indeed, we see sustained high investment levels remaining over the coming three years to accompany the energy transition.

European policies on energy transition accelerated with the agreement on the European Green Deal in December 2019. This plan emphasizes the path toward a net zero economy by 2050, providing greater visibility on future power generation technology mix and eventually unlocking capital for investments in green infrastructure. This Green Deal plan now takes another turn with COVID-19 by being identified as a pillar of the European economic recovery. At the same time, we recognize that the Green Deal and other national stimulus packages for infrastructure will not only take time to materialize (not expected to take place before 2021) and will be spread over the decade. This is therefore not a short-term boost.

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The COVID-19 crisis also highlighted European utilities' significantly decreased exposure to merchant power activities and the relative defensive business profile they have built in recent years. This is supported by material disposals of conventional thermal generation, repositioning in networks and significant growth in long-term contracted renewables. In this context, most of the sector will be able to cope with the currently weaker power price environment and lower power demand. We expect this sector trend toward lower exposure to volatile merchant power market will continue in the coming three years.

Related Research

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S&P Global Ratings, S&P Global Platts Analytics, and S&P Global Market Intelligence are separate, independent divisions of S&P Global.

This report does not constitute a rating action.

Primary Credit Analysts:Trevor J D'Olier-Lees, New York (1) 212-438-7985;
trevor.dolier-lees@spglobal.com
Massimo Schiavo, Paris + 33 14 420 6718;
Massimo.Schiavo@spglobal.com
Pierre Georges, Paris (33) 1-4420-6735;
pierre.georges@spglobal.com
Aneesh Prabhu, CFA, FRM, New York (1) 212-438-1285;
aneesh.prabhu@spglobal.com
Obioma Ugboaja, New York + 1 (212) 438 7406;
obioma.ugboaja@spglobal.com
Secondary Contact:Emeline Vinot, Paris (33) 1-4075-2569;
emeline.vinot@spglobal.com

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