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Will Rising Inflation Threaten North American Investor-Owned Regulated Utilities' Credit Quality?


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Will Rising Inflation Threaten North American Investor-Owned Regulated Utilities' Credit Quality?

After a prolonged bout with COVID-19-induced economic malaise, the U.S. economy is showing strong signs of renewed growth. S&P Global economists now forecast real GDP growth for 2021 and 2022 of 6.7% and 3.7%, respectively. With this increase in economic activity has come rising concerns about inflationary pressure. Recent reports have sounded alarms with increases noted in everything from labor costs, amid a shortage of qualified workers, to higher costs for commodities and materials including metals, corn, and gasoline.

While the Federal Reserve Bank will likely take steps to contain this threat in line with its policy objectives, the timing of any policy changes is uncertain. The most recent data released during mid-June indicated that the CPI rose 5.4% in June from the prior year, which could make it more difficult for a utility to offset these costs on a timely basis through traditional rate increases. While our economists expect the jump in inflation to be largely transitory, they recently noted that the risk that U.S. inflation will stay higher and last longer than our earlier forecasts could force the fed to move on interest rates earlier than planned, potentially fueling market volatility and widening spreads on debt. Although inflation is not a new challenge for utilities, it had taken a backseat to other more pressing problems the sector faces, such as dealing with the energy transition, record debt burdens, and the potential for more rigorous environmental regulation. Now, recent headlines remind us that utilities tend to face pressure to raise rates during periods of cost inflation and that regulatory lag can constrain their financial performance.

In this report, we focus on North American regulated investor-owned utilities, and examine how various economic indicators, including CPI and producer price index (PPI) data, correlate to the changes in revenues, gross margins, and cash flows. We also assess the likely impact on key credit metrics that are already under strain in the sector and offer some views on the potential of inflation risk further constraining credit quality among investor-owned utilities.

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Regulatory Lag Or Riders To The Rescue

With inflation risks rising, the ability to recover costs through rates on a timely basis will become increasingly important to utilities' financial strength. While we evaluate each regulatory relationship on its own merit, in general, we consider such regulatory mechanisms as rate surcharges, formula rate plans, and the use of partly or fully forecast test periods in base rate case proceedings to be supportive of credit quality during times of inflationary cost pressure.

Rate surcharges that provide for recovery of costs outside of a base rate case and are updated periodically could boost the timeliness of cost recovery. Surcharge updates could include a revised return on capital used for determining the cost levels the utilities recover through the surcharge. Surcharges could also relate to capital investments while construction is occurring, providing utilities with an opportunity to reflect increased costs including financing costs. Still other rate surcharges provide recovery of operations and maintenance expenses on new investments once operations begin and outside of rate case. That would allow for quicker rate recovery of operating costs on new generation, particularly if we begin to see increased costs from inflation. Rate surcharges for fuel, purchased power, and natural gas can be updated to capture rising commodity costs.

Similarly, formula rates that reset periodically, or at least annually, will provide quicker rate recovery of escalating costs from inflation. This would include higher interest costs and possibly rising costs of equity.

For base rate cases, utilities can use partly or fully forecast test periods to capture inflationary pressures in expenses and funding costs and help reduce lag in cost recovery. As a comparison, historical test periods result in significant regulatory lag since rates are set at levels based on older data. If inflation steps up, this regulatory lag could materially lengthen, weakening a utility's financial measures even further than during periods of low inflation. During inflationary times, credit quality benefits from forecast test periods and less so from updated historical test periods.

For cases where there are few rate surcharges available in a regulatory jurisdiction, or if these surcharges are not periodically updated, more frequent rate case filings by utilities will help them recover higher costs. The faster a commission approves new rates, the quicker cash flow improves and the better a utility's chances of earning its authorized return due to reduced regulatory lag. If a commission cannot issue a final ruling in a timely manner, its ability to issue an interim rate ruling provides rate relief and lowers financial uncertainty about ultimate rate recovery.

Correlation Between Utility Gross Margin Growth And Macroeconomic Factors
Utility type Real GDP growth (%) Consumer prices growth (%) Producer prices growth (%)
All utilities 2 24 21
Electric utilities (10) 17 13
Gas utilities 30 44 52
Multi-utilities 23 21 22
Water utilities 10 (4) (21)
Note: Correlation above 70% is considered strong, between 30%-70% is considered good correlation, and below 30% is considered a weak correlation. Source: S&P Global Ratings.

Credit Measures Are Already Under Pressure

Unfortunately for many utilities in the sector, the threat of inflation comes at a time when credit metrics are already under pressure relative to downside ratings thresholds. Based on the data correlation analysis above, we expect that rising inflation will remain only somewhat positively correlated to revenue growth and margin gains. While we've seen positive revenue growth correlations to inflation over the past 20 years, cost recovery is unlikely to recapture 100% of the inflation due to regulatory lag. The data suggests that we can expect revenue and margin growth when inflation increases, although these gains occur at a slower pace then necessary to fully recover costs. Thus we expect some incremental pressure on funds from operations during periods of rising inflationary pressure. At the same time, we note that GDP increases typically are associated with rising capital spending and higher debt levels in the sector.

Given these observations, and the added concern that inflationary pressure could be accompanied by a rising interest rate environment and wider spreads, we believe that a period of prolonged inflation could further constrain credit metrics for some utilities. Higher rates will also pressure unhedged variable rate borrowings and raise the costs of refinancing fixed-rate debt maturities. This comes as companies in the sector have already added record levels of debt to offset historically high capital spending aimed at modernizing the grid, building new transmission lines, reducing coal generation, and adding renewable power investments.

Taken together, if inflation increases last longer than currently expected, we could see somewhat reduced profitability from regulatory lag coupled with higher interest rates and increasing debt burdens. These factors could add to an already downward trajectory in key credit metrics in the sector.

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Some Utilities Are More Exposed To Inflationary Risks

We expect companies operating with minimal financial cushion will be more susceptible to rising inflation risks and regulatory lag. We believe this would likely include Sempra Energy, Edison International, PG&E Corp., Consolidated Edison Inc., Southern Co., and Puget Energy Inc.. All of these companies currently have a negative outlook and have been consistently operating with less than 100 basis points of cushion from their funds from operations to debt downgrade threshold. Additionally, they are operating with negative discretionary cash flow reflecting their robust capital spending plans. This spending is earmarked for costs involved in reducing their carbon footprint, enhancing safety and reliability, and, in the case of California's utilities, wildfire mitigation technology. Each company requires timely recovery of costs. In this scenario, inflation combined with regulation lag could lead to a weakening of credit quality. While many of these companies have riders and other regulatory mechanisms that have the potential to protect them from much of the inflation risks, because the degree of financial cushion is relatively small, even modest incremental negative financial results could hurt their credit quality.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Kyle M Loughlin, New York + 1 (212) 438 7804;
Gerrit W Jepsen, CFA, New York + 1 (212) 438 2529;
Gabe Grosberg, New York + 1 (212) 438 6043;
Research Assistant:Sumeet P Ghodke, Pune

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