During the past six months a number of utilities have sold or spun off interest in their midstream assets, including Dominion Energy Inc. (DEI; BBB+/Positive/A-2), DTE Energy Co. (DTE; BBB+/Stable/A-2), Sempra Energy (Sempra; BBB+/Negative/A-2), CenterPoint Energy Inc. (BBB+/Stable/A-2), OGE Energy Corp. (BBB+/Negative/A-2), and Consolidated Edison Inc. (A-/Negative/A-2). While spinning off midstream assets by utilities is not unprecedented, the recent pace of activity has been elevated and has spawned a number of new midstream issuers (see table 1).

Table 1

This is a clear strategy shift by the utility industry especially considering that until recently some of these companies were pursuing midstream opportunities. For example, in 2019, DTE acquired the Haynesville Basin midstream gas assets for $2.25 billion and then in 2021 spun it off as part of DTM. In 2016, Con Edison acquired a 50% interest in a natural gas pipeline and storage facilities (Stagecoach Natural Gas Services LLC), for about $975 million and in 2021 sold its stake to Kinder Morgan Inc. (KMI) for about $612 million. Also, over the past three years, Sempra Energy (SE) has been investing heavily in liquid natural gas (LNG) assets, completing three Cameron trains and then in 2020 deciding to build out the Energia Coast Azul LNG (ECA) export project. However, recently SE sold 20% of Sempra Infrastructure Partners (SI) to KKR & Co. Inc.

We believe the main reason utilities are selling their midstream assets is to reduce credit risks while at the same time avail themselves of ample growth opportunities at the lower-risk regulated utility sector.

Midstream Assets Are Higher Risk Than Utilities

Typically, we assess the midstream industry as higher risk than the utility industry, even when the midstream assts are high-quality assets with long-term contracts. The midstream industry is exposed to commodity risks, counterparty credit risks, volumetric risks, and associated environmental, social, and governance (ESG) risks. Additionally, given energy transition initiatives, we expect that reduced demand for hydrocarbons will eventually be reflected in lower prices and revenues for midstream companies as fees and rates are renegotiated. Consistent with these higher risks for the midstream industry, S&P Global Ratings recently revised the midstream industry risk assessment downward to intermediate risk from low risk, incorporating the increasing environmental and social risks posed by climate change, greenhouse gas (GHG) emissions, and the use of hydrocarbons over the longer term.

Another critical risk for the midstream industry is the potential for limited growth. Prospects for building new infrastructure requiring significant permitting remains dim. Various midstream projects have either been significantly delayed (i.e., Mountain Valley Pipeline) or canceled (i.e., Atlantic Coast Pipeline, Jordan Cove LNG, and Keystone XL Expansion) because of more stringent environmental safeguards required in the permitting process and increasing community opposition. We expect the midstream industry will grapple with limited growth over the next decade, which contrasts to the immense growth opportunities within the regulated utility sector.

Utility Growth Opportunities

Over nearly the past two decades, the North American regulated utility industry's capital spending has been growing at an approximate 9% compound annual growth rate (CAGR) and today, the industry's capital spending is at more than $160 billion annually. The utilities have allocated this spending for safety, reliability, and energy transformation initiatives. Over the past decade the industry has reduced its coal generation by about 50%. We expect that most of the remaining coal generating facilities will likely close over the next decade, primarily replaced with renewables and batteries.

Chart 1

The cumulative annual capital spending for Dominion Energy, DTE Energy Co., Sempra Energy, CenterPoint Energy Inc. (CPE), OGE Energy Corp., and Consolidated Edison Inc., all of which have recently sold or spun off midstream assets, is growing at more than 15% since 2018.

Chart 2

Selling Assets To Support Utility Credit Quality

As a result of the utility industry's rising capital spending, discretionary cash flow remains negative. To fund this robust capital spending, the utilities often issue more debt, resulting in weaker financial measures or financial measures with only minimal financial cushion. To alleviate some of this financial pressure, utilities have issued common equity and have sold assets, including midstream assets. The outlooks for OGE, Consolidated Edison, and Sempra Energy are all negative and only Dominion and DTE have sufficient financial cushion from their downgrade threshold.

Chart 3

Selling Midstream Assets To Reduce The Utility Industry's ESG Risks

Another reason why the utility industry may be moving away from midstream assets is ESG-related risks. Utilities are already taking actions to attempt to offset the many ESG risks that could potentially harm their credit quality, which include the following:

• Climate-related risks including wildfires, storms, hurricanes, and extraordinary hot or cold temperatures.
• Regulatory risks. Rising costs and higher capital spending could pressure the industry's regulatory support and expectations of full recovery of such costs from ratepayers.
• Consistent access to the capital markets at a fair price. To the extent that investors are taking environmental concerns into consideration, utilities with higher carbon emissions might not have the same capital market access or pricing as peers, potentially weakening credit quality.
• Stranded asset risk. Should regulators and customers no longer support fossil fuel-based assets and instead determine that full electrification and renewable generation should replace the industry's natural gas distribution system and natural gas-fired generation, these assets could become stranded assets, potentially weakening a utility's financial measures and management of regulatory risk.

Given the ESG risks that already exist within the lower-risk utility industry, it is understandable that the industry would not want to take on the incremental ESG risks the midstream industry faces.

The Midstream Industry's ESG Risks

Much like regulated utilities, midstream companies are trying to strike a balance between addressing the risks of climate change and operating infrastructure that is responsible for providing most of the energy that the U.S. currently consumes and will likely continue to do so for the next few decades. According to the Energy Information Administration (EIA), the consumption of hydrocarbons in the U.S. during the next 30 years will only modestly decline, with gains in renewable energy (to 18% from about 10% in 2020) primarily coming at the expense of nuclear energy and coal (see charts 4 and 5). We believe that means that existing infrastructure will remain valuable, while companies look for attractive opportunities to grow its low-carbon or renewable energy businesses. We expect that in the next few years, midstream companies will focus on reducing greenhouse gas (GHG) emissions, enhancing safety protocols to minimize accidents and spills, and look to be the provider of choice for low- or no-carbon energy ideas such as transporting and storing renewable diesel, bio fuels, and hydrogen.

Chart 4

Chart 5

Credit Considerations For New Midstream Issuers

As the pace of utilities selling or spinning off their midstream assets is accelerating, S&P Global Ratings' analysis of these midstream assets incorporates the following:

• Ownership structure
• Quality of assets and contract
• Leverage

Ownership by a strong parent can result in some uplift to the rating

We expect that midstream assets sold or spun off by a utility would be acquired by a larger corporation, instead of being divested as an independent entity. This reflects the slow growth environment in midstream, reflecting rising environmental restrictions. As an example, Berkshire Hathaway Energy Co. (BHE), a large multi-state corporation, acquired Eastern Energy Gas Holdings LLC (EEGH) in 2020. In February 2021, Energy Transfer L.P. (ET), a large midstream pipeline company with downstream capabilities, acquired Enable Midstream Partners L.P. (ENBL). More recently in June 2021, KMI, one of the largest U.S. midstream companies, acquired Stagecoach, natural gas storage assets located in upstate New York.

We tend to view a significant ownership and control by a well-established and higher rated parent as potentially credit positive. Depending on our assessment of how strong the parent/operating subsidiary relationship, it can potentially result in some ratings uplift for the operating subsidiary.

For example, as early as 2013, we raised our rating on ENBL by one notch to 'BBB-' based on our expectation of support from its higher rated parent, CPE. However, in 2016, we lowered our rating on Enable to 'BB+', given that it no longer benefited from the higher rating on its parent following CPE's announcement that it was evaluating strategic alternatives for its investment. In 2021, CPE ultimately excited its midstream position by selling its interest in ENBL to ET (see table 2 for recent examples).

Table 2

Business profiles tend to benefit from good contracts with a midsize asset base

We consider the quality of the contracts to be key in assessing a midstream company's business risk profile. The lowest risk companies typically benefit from a high proportion of fee-based revenues, with limited commodity exposure. For DTM and EEGH, their high percentage of take-or-pay contracts reduces volumetric risk, improving cash flow predictability. EEGH's credit quality is further supported by the demand-pull nature of its pipelines. SI is also expected to benefit from a high level of contractedness, given Cameron LNG LLC (Cameron) and Infraestructura Energética Nova S.A.B. de C.V.'s (IEnova) contractual profile.

Credit risk for EEGH is mostly mitigated by the counterparty's high credit quality, with the majority being investment grade. Similarly, credit risk for SI is also expected to be mitigated by Cameron and IEnova's high quality counterparties. Conversely, DTM's weaker counterparty credit exposure constrains its credit quality. About 40% of DTM's revenues is dependent on Southwestern Energy Co. (BB-/Watch Pos/--).

Finally, our assessment of a new midstream company takes into account size. However, size can be offset by significant diversity or integration with other business lines. This typically occurs when utilities concentrate their midstream asset base to serve their specific needs.

Financial profiles tend to improve as utilities apply cash flows to deleveraging

For new midstream companies, our assessment of financial policy is important given the lack of a track record. This includes examining the companies' long-term leverage and financing strategies. In general, we expect new entities to initially have debt to EBITDA of 4x-5x, which we assess within the significant financial risk profile category.

For both DTM and EEGH, we expect some strengthening of credit metrics in upcoming years. We expect DTM to de-lever to about 3.8x in 2023 from about 4.2x in 2021 as it has built out most of its asset base, with only modest capital spending going forward (about $100 million to $200 million per year). For EEGH, we also expect some modest strengthening of its financial metrics in upcoming years, with funds from operations (FFO) to debt rising to about 16% by 2022 from about 14.5% today. This primarily reflects EBITDA growth and debt reduction from equity injections. SI's financial metrics will be affected by its more robust capital spending program (of about $3.1 billion from 2021 to 2025), which includes the ECA LNG project and other growth projects at IEnova.

Table 3

What Do We Expect For The Midstream Industry?

We believe the midstream industry is likely to face increasingly limited options for organic infrastructure spending, given that U.S. energy infrastructure is mostly built out and the need for large-scale projects in the future is limited (chart 6).

Chart 6

Although more stringent federal and state regulation is making it increasingly difficult to build new infrastructure when needed, it has made existing pipelines and infrastructure more valuable. In our view that could lead to more industry consolidation and perhaps additional divestitures from regulated utilities. M&A could be one way for midstream companies to grow in the face of energy transition programs and shifting demand preferences.

However, despite the ongoing transition to a lower carbon intensive economy, we expect that existing midstream assets will continue to be needed over the next several decades because the U.S. will continue to rely on the consumption of hydrocarbons to meet most of the country's energy needs. As such, we expect that the midstream industry will continue to play a critical role in the broader energy value chain.

Related Research

• Industry Top Trends Update: Regulated Utilities North America, July 15, 2021
• Industry Top Trends Update: Midstream Energy North America, July 15, 2021