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Credit FAQ: High Capital Spending Limits American Electric Power Co. Inc.'s Financial Cushion

American Electric Power Co. Inc. (AEP) has announced plans to add nearly 16,600 megawatts of renewable generation by 2030 to replace about 8,000 megawatts (MW) of retiring fossil fuel-based generation. The company also has multiple purchase power agreements expiring over the next 10 years. As such, S&P Global Ratings believes AEP's financial measures will remain at the lower end of the range for the financial risk profile category. In addition, management has announced plans to purchase the coal-fired Rockport Generating Station (RGS) unit 2 from its existing owners for about $115 million after the leases between the current owners and AEP's affiliates expire in late 2022. Following a strategic review, AEP also launched a process to sell utility Kentucky Power Co. (KPCo).

Here, we answer questions about AEP's capital spending and funding, divestiture, revised clean-energy transition plan and discuss how they affect the company's credit quality and ratings.

Why did S&P Global Ratings take several rating actions and revise rating outlooks on AEP and its subsidiaries in late April 2021?

We revised the outlooks on AEP and its subsidiaries, excluding KPCo, to negative from stable because we believe regulatory risk is modestly increasing and financial measures are weaker due to an aggressive capital spending strategy.

We lowered our issuer credit rating (ICR) and issue-level rating on its KPCo's debt to 'BBB+' from 'A-' following the change in KPCo's group status to moderately strategic from core. Our stand-alone credit profile (SACP) of KPCo remains 'bbb'. Additionally, we placed our ratings on KPCo on CreditWatch with developing implications based on parent AEP's announcement that it plans to sell the utility.

We also changed AEP's subsidiary Indiana Michigan Power Co.'s (IMP) group status to highly strategic from core, after the parent's announcement that it will try to sell KPCo. At the same time, we revised IMP's financial risk profile to intermediate from significant based on our expectation that its funds from operations (FFO) to debt will be consistently above 23%. This resulted in a revision of our SACP on IMP to 'a-' from 'bbb+'.

See "American Electric Power Co. Inc. Outlook Revised To Negative On High Capital Spending and Limited Financial Cushion," April 28, 2021, and "Kentucky Power Co. Downgraded To ‘BBB+’, On CreditWatch Developing On Announced Sale By Parent American Electric Power," April 28, 2021, for more details on the rating actions.

What is the rationale for the change to KPCo's SACP and group status, and the placement of the ratings on CreditWatch Developing?

AEP announced its intention to sell KPCo, leading to our assessment that KPCo's group status is now moderately strategic rather than core. We believe AEP's plan to sell KPCo will help provide funding for the holding company's aggressive capital spending plan. With KPCo's group status changing to moderately strategic, the utility only receives a one-notch uplift above its SACP due to limited group support. Although the utility may be sold, its continued access to the AEP money pool indicates it's receiving some group support. Thus, we revised our ICR on KPCo to 'BBB+' from 'A-'.

The CreditWatch placement reflects material uncertainty around KPCo's ultimate buyer or the buyer's credit quality. Once we receive more clarity about the timing of the sale and ultimate buyer, we will re-assess the CreditWatch listing.

What is the rationale for the change in IMP's SACP and group status?

In recent years, IMP's financial credit measures have consistently improved from the higher end of the significant category upward to the lower end of the intermediate category. Considering the improved financial credit measures, we revised our assessment of its financial risk profile to intermediate from significant based on our expectation that its stand-alone FFO to debt will remain consistently above 23% over the next few years. As such, we also revised our assessment of IMP's SACP to 'a-' from 'bbb+'.

The revision of IMP's group status to highly strategic from core reflects the utility's smaller size in each of the states in which it operates--Indiana and Michigan--its large exposure to nuclear generation, and its longer-than-expected exposure to coal-fired generation, particularly with the forthcoming purchase of the second unit at the RGS in late 2022. In the near future, we believe this purchase of RGS 2 limits IMP's new renewable capacity addition, further strengthening our view of its group status of highly strategic.

Why did S&P Global Ratings revise the rating outlook on AEP and most of its subsidiaries to negative from stable?

The negative outlook incorporates our assumption that AEP's management of regulatory risk will modestly weaken as it significantly increases its capital spending to add nearly 16,600 MW of renewable generation by 2030 to replace about 8,000 MW of retiring fossil fuel-based generation, as well as its expiring purchase power agreements over the next 10 years. The company's strategy of high elevated capital spending to significantly reduce its carbon footprint increases the associated execution risks, specifically effectively managing all its stakeholders, including its customers, employees, and regulators. Although AEP has indicated cumulative equity issuances of more than $3.5 billion through 2023, the aggressive capital spending plan that averages $7.5 billion per year will result in AEP's financial measures through 2023 remaining at the lower end of the benchmark range for its financial risk profile category.

How has AEP's 2021 capital spending plan changed from its 2020 plan?

Compared to AEP's 2020 capital spending plan for the years 2021 to 2024, AEP increased its capital spending in its 2021 plan for the same time period by about 13%. The primary reason for the increase in capital spending is the company's decision to accelerate its clean-energy strategy to own more emissions-free generation. This is evident in AEP's five-year capital spending plan that for its 2020 plan, AEP expected to spend $200 million on regulated renewable generation. Whereas the company's 2021 plan, increases spending to $2.8 billion, a large increase in renewable generation (see chart 1).

Chart 1

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The additional capital spending over the 2021-2023 period will add pressure to AEP's weaker financial measures. Because of the increased capital spending, along with funding costs incurred during Winter Storm Uri in February 2021, AEP will likely need to access the capital markets more than expected based on the data provided in the first quarter of 2021 earnings call presentation (see table).

American Electric Power Co. Inc.--Key Financial Data
(all values in $ mil.) 2021 2022 2023
Sources of Fund
Cash from Operations 3,800.0 6,000.0 6,400.0
Equity Units Conversion 0.0 805.0 850.0
Equity Issuance 600.0 1,400.0 100.0
Uses of Funds
Capital Expenditure 7,500.0 8,000.0 6,900.0
Investing Activities 300.0 300.0 300.0
Common Dividends 1,400.0 1,500.0 1,500.0
Debt Maturities 2,100.0 3,100.0 1,500.0
Capital Needs 6,900.0 4,695.0 2,850.0
Source: Q1 2021 Earnings Presentation for AEP.

How are the current business segments reflected in S&P Global Ratings' assessment of AEP's existing business risk profile as excellent?

AEP is largely composed of regulated electric utility operations. Along with utility businesses, AEP also operates nonregulated generation and power marketing businesses, both together contributing a total of around 5% to group EBITDA. AEP's regulated utility operations consist of vertically integrated electric utilities; and, electric transmission and distribution (T&D) operations. Vertically integrated utilities include IMP, KPCo, Appalachian Power Co., Public Service Co. of Oklahoma (PSO), and Southwestern Electric Power Co. (SWEPCO). The T&D businesses consist of AEP Texas Inc., Ohio Power Co., and AEP Transmission Co. LLC.

Although only by a slight majority, AEP's operations continue to be weighted towards vertically integrated utilities. Over time, AEP has been growing it electric T&D utilities, particularly transmission operations. This is indicated over the past seven years by T&D capital expenditures increasing about 15%. T&D's percentage of total assets increased by approximately 10% from 2014, as well as its contribution toward consolidated EBITDA increased by 15% from 2014 (charts 2 and 3 depict these trends).

Chart 2

image

Chart 3

image

While capital expenditures for T&D operations has been over 50% of total capital spending, we expect spending on vertically integrated operations to rise to about 50% in 2022, but again decline below 50% starting in 2023. The spending in vertically integrated electric operations captures AEP's acceleration of new renewable generation (see chart 4). In its clean energy strategy, the company plans to close coal-fired generation and add renewable generation. As previously mentioned, by 2030 AEP expects to reduce coal generation capacity by the approximately 8,000 MW, and to add about 5,900 MW of solar generation capacity and about 10,700 MW of wind generation capacity. Also, AEP plans to add about 2,300 MW of natural gas generation capacity. This uptick in capital spending at the vertically integrated operations reflects the transition toward emissions-free generation.

Chart 4

image

How does AEP's generation in 2019 compare with peers in the same year?

AEP's 2019 coal-fired generation capacity was 13,230 MW, second to Duke Energy Corp. (Duke) at about 17,000 MW and marginally more than Southern Co.'s (Southern) 11,800 MW. Xcel Energy Inc. (Xcel) has the least amount of coal capacity at 6,500 MW, about one-half of that of AEP (see chart 5). Regarding natural gas generation, AEP has the lowest megawatts at 7,700 MW. At 7,900 MW, Xcel runs a close second while Duke has 20,260 MW and Southern has the most at 22,500 MW. Duke and Southern have slightly less than three times as much natural gas generation as AEP.

Chart 5

image

Regarding generation capacity mix, as per 2019 the Edison Energy Institute (EEI) data, AEP's coal generation capacity is about 50% of its total capacity (see chart 6). This is highest among peers Duke, Southern, and Xcel. Although coal capacity relative to total capacity is higher, AEP has the lowest reliance on natural gas generation at about 30% of total generation. If AEP successfully executes its clean energy plan and retires coal plants by the end of 2030, the company's generation capacity mix will dramatically change with less fossil fuel generation, more quickly than peers.

Chart 6

image

Although AEP's generation capacity mix is skewed toward coal, capturing about 50% of total generation capacity, capacity mix is not accurately depicting AEP's actual generation produced. As of year-end 2020, AEP's actual net generation based on megawatts per hour (MWh) was 45% coal, 24% nuclear, 18% natural gas, and 13% renewables, including wind and solar. Less reliance on coal for energy has led to AEP's steady reduction in carbon dioxide (CO2) emissions. Prospectively, the steady closing of coal plants and addition of renewable generation should result in even further reductions in CO2 emissions.

Would the sale of KPCo improve the generation mix for AEP?

Yes, the KPCo sale would reduce AEP's coal capacity by an incremental 5%-10%. KPCo's generation consists of 780 MW of coal capacity in West Virginia and 280 MW of natural gas capacity in Kentucky.

How has AEP performed on reducing CO2 emissions?

In recent years, AEP has reduced its CO2 emissions in large increments through the retirement of coal-fired generation plants. By the end of 2020, AEP decreased its CO2 emissions by about 65% compared to 2014 levels (see chart 7). This is one of the largest reductions among its peers besides FirstEnergy Corp. (FE), which divested most of its carbon-intensive assets (see chart 8). Unlike FE, AEP continues to own many fossil-fuel based generation assets and has been actively closing coal plants to reduce CO2 emissions. We expect the company to continue to decrease its CO2 emissions with ongoing retirement of coal power plants.

Chart 7

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Chart 8

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However, based on 2019 reported data by EEI, AEP continues to be one of the top four CO2e emitters in its peer group, largely because of the size of the company's generation fleet along with its power plant fleet concentrated in coal generation plants (see chart 9).

Chart 9

image

What is AEP doing to address its exposure to coal-fired generation?

After closing about 1,100 MW in 2020, AEP had a total coal-fired generation capacity of 12,119 MW.

In its clean-energy plan (see chart 10), AEP expects to retire the following plants, encompassing a significant portion of its coal-fired generation capacity:

  • Dolet Hills,
  • Northeastern 3,
  • Pirkey,
  • Rockport,
  • Welsh, and
  • Cardinal.

The retirement of these coal-based generation plants will reduce its existing coal-fired capacity to 6,545 MW by the end of 2030, or about a 45% reduction from the 2020 capacity. After 2030, the remaining active coal-fired generation plants will be Flint Creek and Turk, both in Arkansas, and Amos, Mitchell, and Mountaineer, all located in West Virginia. If AEP sells KPCo, the Mitchell plant's 780 MW of coal-fired capacity will likely be included in the sale, further reducing AEP's coal generation to 5,765 MW.

Chart 10

image

With the transition of its generation fleet from largely coal powered to more renewable focused, AEP will reduce carbon emissions 80% by 2030 compared to 2000 emission levels. And by 2050, the company will be net zero. Through 2030, replacing the retiring 5,600 MW coal-fired generation capacity will be 16,600 MW of renewable generation capacity and 2,300 MW natural gas generation capacity, with the majority of the natural gas capacity provided by IMP and SWEPCO. Considering the typical capacity factors of renewable generation, we believe AEP will ultimately have to add even more renewable generation capacity to supply customers.

Besides CO2, has AEP addressed other air emissions and coal combustion byproducts?

Over the past 20 years, AEP significantly decreased and continues to decrease its nitrogen oxide (NOx), sulfur dioxide (SO2) and mercury emissions. In terms of managing coal ash, AEP has converted its fly ash ponds to dry systems. However, bottom ash is still processed through ash ponds for further settling before final discharge. All AEP facilities that discharge effluents have National Pollutant Discharge Elimination System (NPDES) permits that govern the discharge of treated wastewater and meet applicable water quality standards. In response to proposed and final regulations governing the disposal and beneficial re-use of fly ash and bottom ash, AEP is considering plans to upgrade or close and replace these existing facilities and conduct any required remedial actions.

This report does not constitute a rating action.

Primary Credit Analyst:Gerrit W Jepsen, CFA, New York + 1 (212) 438 2529;
gerrit.jepsen@spglobal.com
Secondary Contact:Daria Babitsch, New York 917-574-4573;
daria.babitsch1@spglobal.com
Research Contributor:Sumeet Ghodke, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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