Gas Connection Prohibitions Can Create Credit Risks For Municipal Utilities

The embrace of decarbonization is spurring more legislative and regulatory initiatives banning the installation of gas appliances in new construction and introducing prohibitions on replacing existing gas appliances with gas-fired devices. S&P Global Ratings finds that the question of whether such rules will erode municipal gas systems' commodity sales volumes and revenues, and lead to downgrades depends to a great extent on whether a utility operates in a jurisdiction that is protective of gas sales. Even in jurisdictions that move to bar new gas connections, in our opinion, the effect on utilities' sales and revenues should be manageable because economic barriers to replacing gas appliances can perpetuate historical sales volumes in the intermediate term, and we expect long-term declines will be gradual rather than disruptive.

Bans On New Gas Connections Are Slowly Gaining Traction

The non-profit Building Decarbonization Coalition reports that following the 2019 adoption and 2020 implementation of regulations by the city council in Berkeley, Calif., prohibiting new residential and commercial buildings from connecting to the gas network of the investor-owned utility serving the city, another 101 cities, counties, and states adopted similar mandates. However, the 102 governmental units are found in nine states and the District of Columbia (chart 1). Gas connection moratoriums are most prevalent in California, Colorado, and Washington State.

Chart 1

In addition to restrictions affecting new construction, the directives governing new natural gas connections also prohibit installing gas-fired replacement appliances. However, so far, none of the initiatives mandate replacing existing, operational gas-fired appliances.

The Location Of A Utility's Service Territory Can Protect Credit Quality

S&P Global Ratings' U.S. public finance analysts rate 25 stand-alone municipal natural gas utilities and 15 combined municipal utility systems that include a natural gas utility among their portfolio of services.

Table 1

Stand-alone gas utilities in Alabama, Indiana, Tennessee, and Texas represent 22 of the 25 stand-alone gas utilities. These four states are among the 20 that have enacted legislation prohibiting municipalities from adopting rules banning new gas connections like Berkeley's (chart 2). These laws are commonly referred to as "preemption laws" or "bans on bans." Among the 15 combined utilities that provide natural gas together with other services, all but five operate in states that have preemption laws.

Chart 2

Consequently, unless the federal government adopts Berkeley-like laws or regulations that override state legislation, we believe that demand for natural gas among the 22 stand-alone and 10 combined municipal gas systems operating in the "bans on bans" states are unlikely to face material demand erosion. Our expectation that these utilities will exhibit stable natural gas sales should continue to support our current ratings. In addition, if gas appliance bans are adopted that weaken the gas sales of the five combined utilities that operate without the protections of preemption legislation, we believe a shift of commodity sales and revenues to their electric operations could temper the effects of eroded gas margins and help preserve the aggregate revenues pledged to bondholders and ratings.

The eight rated municipal stand-alone and combined gas utilities operating in states without preemption laws are in:

• California (one);
• Nebraska (two);
• Massachusetts (one);
• North Carolina (one);
• Pennsylvania (one); and
• South Carolina (two).

We believe Nebraska and Pennsylvania are unlikely candidates for barring gas appliances because both states host meaningful fracking activity, which suggests a gas-friendly posture.

The municipal gas utility serving Susanville, Calif., is not subject to an electrification mandate. However, based on California's historical role in advancing environmental regulations and the numerous existing decarbonization and electric-only mandates affecting other governmental units within the state, Susanville's municipal gas system could face a heightened likelihood of exposure to appliance mandates, along with negative rating pressures compared with the municipal gas systems we rate in other states. Separate from the decarbonization exposure, we have assigned a negative outlook to our 'A' underlying rating on the Susanville utility because of the potential closure of its largest customer, which is also the city's largest employer.

Although the utility providing gas service to Middleborough, Mass. is not subject to an electrification mandate, there is precedent within the state for bans on new gas connections. In addition, Boston's ban on new gas connections might influence Middleborough lawmakers.

Currently, there are insufficient indications to gauge the susceptibility of the North Carolina and South Carolina gas systems to new connection bans.

We will continue to monitor legislative and regulatory developments that might affect the gas sales, revenues, and credit ratings of the municipal gas systems operating in states that have not insulated their gas utilities from new gas connection prohibitions.

The Transition Will Not Happen Overnight

We do not associate imminent negative rating pressures with either the municipal gas utility systems protected by preemption laws or utilities that might be more susceptible to new gas appliance connection bans in the absence of preemption laws. Although none of the 40 rated municipal gas utilities are subject to beneficial electrification initiatives, where they exist, their focus is on new construction and restrictions on the replacement of existing appliances. Consequently, although the gas appliance prohibitions have the potential to constrain growth opportunities, we do not expect the application of such mandates to municipal gas utilities will produce imminent and significant cannibalization of existing gas demand through appliance conversions. We believe that efforts to compel consumers to replace functioning appliances will engender significant resistance. We also expect consumer adoption will be very gradual because of the high costs of purchasing and installing electric appliances to replace gas appliances.

The Inflation Reduction Act's Incentives Might Not Be Enough To Induce Voluntary Conversions

Although the Inflation Reduction Act (IRA) provides tax credits to property owners who replace gas furnaces and water heaters with electric heat pumps, we believe that many people will find the incentives do not create a sufficient inducement to replace equipment that is still functional.

The IRA provides a tax credit of up to 30% of the cost of purchasing and installing a heat pump and a water heater, but the credit is capped at $2,000 per year for a combination of these appliances. Therefore, the IRA tax credits might not provide enough of an inducement to replace functioning gas appliances. Because property owners will need to absorb the remaining 70% of conversion costs not covered by tax credits, we believe costs could present an economic barrier to conversions that might otherwise erode municipal gas utilities' commodity sales and revenues, and weaken ratings. However, in some states, adding state-level incentives to federal incentives could help consumers overcome the economic hurdles.

Amped Up

Adding a bevy of electric appliances to homes and businesses will increase the amperage demands on buildings' behind-the-meter electrical panels and the in-front-of-the-meter utility transformers affixed to poles throughout distribution systems. Irrespective of whether a property owner upgrades the behind-the-meter electrical panel or the utility upgrades its neighborhood transformers, consumers, who already face significantly elevated utility bills because of inflationary pressures, will shoulder the higher costs of system upgrades on both sides of the meter. Such costs might translate into reduced electric bill affordability and greater public resistance to proposals to adjust rates to preserve financial metrics and ratings.

In the intermediate term, we believe few municipal gas utilities will face negative rating pressures related to the energy transition because many of the municipal gas utilities we rate are shielded by state prohibitions on new gas appliance interconnections. At the same time, those utilities that lack legislative or regulatory protections are unlikely to experience diminished gas sales for some time because of anticipated consumer resistance to costly replacements of functioning gas appliances.